Wall Street's Bold Return to Short-Volatility Bets Amidst AI Boom

📝 SUMMARY: Amidst the artificial intelligence frenzy sweeping through Wall Street, a less flashy but equally significant trend is making a comeback: short-volatility trading. This strategy, known for its catastrophic implosion in early 2018, is reemerging on a much larger scale, primarily through exchange-traded funds (ETFs) that sell options on stocks or indexes to boost returns. These ETFs have seen their assets almost quadruple within two years to an unprecedented $64 billion.

Short-volatility positions, though lucrative in a stable market, carry inherent risks, especially with looming event risks like the US presidential election. The strategy's resurgence has become a focal point of investor inquiries, reflecting a cautious curiosity about its market impact. While the structural changes in these new ETFs—combining options sales with long stock positions—may mitigate some risks compared to their 2018 predecessors, the broader implications of these strategies contribute to market complexity and potential volatility suppression.

The explosive growth in derivatives trading, highlighted by a surge in US equity options volume, amplifies this dynamic. Income ETFs, capitalizing on this demand, sell calls or puts against their equity holdings, potentially capping upside gains but profiting from market calm. The shift towards these derivative income funds, predominantly housed within ETFs, reflects a significant evolution in market strategies.

However, the shadow of past volatility spikes, such as the 2018 "Volmageddon," looms large, raising questions about the sustainability and safety of these trades. Despite reassurances from experts who see the current boom as a response to retail investor demand rather than a gamble on falling volatility, the complexity and size of these trades obscure their total market impact.

As Wall Street navigates this revived interest in short-volatility strategies, the balance between seeking steady returns and managing systemic risk remains delicate. The historical precedents and the intricate web of market dynamics underscore the need for vigilance in a trading environment increasingly influenced by derivatives and speculative bets.

🔍 SOURCE: https://www.bloomberg.com/news/articles/2024-03-10/the-short-volatility-trade-roars-back-on-wall-street