Explaining Short Volatility and How It Took a Beating: QuickTake

(Bloomberg) -- A popular investment strategy for riding the unusual recent calm of global stock markets is suddenly in tatters. It’s called short volatility, and since around 2015 has been something of a one-way bet thanks to the orderly rise of global equities. That’s all changed following Monday’s rout, putting at risk an estimated $2 trillion tied to the strategy and stoking concerns of wider repercussions.

1. What is short volatility?

A strategy of betting against turbulence in equity markets. Because there’s been very little for more than two years, investors taking such bets have earned handsome returns. And funds that have followed the strategy have attracted massive inflows. The two largest exchange-traded products that wager on low volatility took in $1.7 billion in January, a record.

2. How do investors wager on market turbulence?

By trading indexes that track volatility. Taking a step back, traders can bet on the future direction of securities using options -- contracts that give the holder the right to purchase a security in the future at a pre-determined price. From those options, mathematical constructs calculate how much traders expect a security’s price to fluctuate. That fluctuation is known as the implied volatility. If, for instance, options cover a small range of prices, the implied volatility is low -- as has been the case for equities since 2015.

3. What are those indexes called?

The most widely traded volatility indexes include the Chicago Board Options Exchange SPX Volatility Index -- known as the VIX -- for the S&P 500 Index. There’s also MOVE for the U.S. Treasury bond market. Another way of thinking about volatility indexes is as gauges of fear -- because of the insight they give into traders’ worries.

4. How worried have equity traders been?

Hardly at all, judging by the VIX. While its average level since 1990 has been 19.3, during the past three years that number has been close to 14. But during the market rout on Monday, it soared to 38.8, its highest level since August 2015, and rose by a record amount. That was great news for anyone owning investments that track the index but a disaster for the short volatility funds that take inverse bets on the VIX. Those investors ran for the exits on Monday as they tried to cover their trades.

5. How popular has short volatility become?

Assets in related exchange-traded products have risen to more than $3 billion, a record. Estimates of how much money is tied up in the strategy overall vary, but Chris Cole of the Artemis Capital Advisers hedge fund puts the total at more than $2 trillion. That’s roughly the size of India’s economy.

6. Should we be worried?

If you own a VIX-related exchange-traded product, certainly. (Here’s a list of big investors -- one Nomura fund has already announced its early redemption). As for the wider global markets, funds and banks face limits on the amount of risk they can hold on their books. As a result of the spike in volatility, they may have to sell risky assets -- or desist from buying them -- to meet those limits. That could have implications for assets including and beyond stocks in the coming weeks and months.

The Reference Shelf

• A QuickTake on the worry that was low volatility.
• What exactly happened to stocks?
• Hedge fund: I told you.
• A dip in asset prices might be a good thing, says Tyler Cowen.

--With assistance from Joanna Ossinger and Garfield Reynolds

To contact the reporters on this story: Grant Clark in Singapore at gclark@bloomberg.net, Rachel Evans in New York at revans43@bloomberg.net.

To contact the editors responsible for this story: Sarah McDonald at smcdonald23@bloomberg.net, Joanna Ossinger

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