As Cole explains:
This is all great as long as volatility is low or dropping, as long as markets are stable.But, in the event that we have a reversal in this, there’s two trillion dollars of equity exposure that self-reflexive-driving lower vol can reverse in a quite violent way. And this is just equity vol, mind you:
Moving on to another topic that Coletouched on in a paper he published entitled “Reflexivity in the Shadows of Black Monday 1987”Townsend asks him about corporate buybacks, and their presences as a type of “long-vol” influence on the market. As it happens, these buybacks are just one piece of a large, global “short vol” trade.
Townsend asks Cole to elaborate, and Cole explains that explicitly betting on short volatility by buying an inverse-VIX ETF, or directly shorting the underlying options yourself, is only one small component of the $2 trillion figure mentioned above.
The short-vol trade – if you look at short volatility and you think about what volatility really is – it’s a bet on stability. And when you’re betting on stability, that’s a myriad of different bets.
Part of that is the expectation that markets remain low volatility or low realized volatility. Part of that is short Gamma – so there is this implicit short Gamma exposure.
Part of that is a bet that correlations remain stable. Or that different market relationships remain anti-correlated with one another. Or that implied correlations are dropping. Or realized correlations are dropping.
And the other aspect of the short-volatility bet is that interest rates remain low or go lower.
So if we look at each of these different factors, these are the risk exposures that you will have when you own a portfolio of short options. And, if you own a portfolio of short options you are short Vega, you’re short Gamma, you’re short correlation, you’re short interest rates.
What we’ve seen now with this short-vol trade, explicitly and implicitly, is that various financial engineering strategies out there that have become dominant in the marketplace – we’re talking about the largest hedge funds in the world employ these strategies – that are just replicating the exposures of a short-options portfolio.
And of course the VIX trade gets a lot of attention, but it’s the smallest portion of the short-vol trade. This is what we call explicitly shorting volatility. This is where you’re literally going out and you’re shorting an option. Or you’re shorting a volatility future.
But in the VIX space, that’s only about $5 billion worth of short exposure.You have about $8 billion of vol-selling funds, according to Bloomberg. And then about $45 billion (estimated) in pension over-writing strategies, these short-port or short-call strategies the pensions are doing.
So, in total, there’s about $60 billion of explicit short volatility. Which is big. But that’s not the most concerning aspect.
The bigger aspect is this $1.4 trillion in implicit short volatility strategies. These are replicating the exposures of a portfolio of short options, even though they may not be directly selling derivatives or directly selling optionality.
Among these implicit strategies are the $600 billion worth invested in risk-parity strategies. $400 billion in volatility-control funds. And about $250 billion of risk premium strategies…