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Wall Street's Growing Worry: The Return of Short-Volatility Trades

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Ticker Tea
February 13, 2024

📝 SUMMARY: Wall Street is once again on edge about the resurgence of short-volatility trading strategies, reminiscent of the "Volmageddon" debacle in February 2018 that saw the CBOE Volatility Index ($VIX) spike and erase billions from trades betting against market volatility. According to a recent Bloomberg Markets Live Pulse survey, a significant majority of the 377 respondents (71%) consider these short-volatility trades dangerous for generating income, with 59% viewing the current trend as a potential market threat. Despite the cautious stance, more than half of those employing short-vol strategies acknowledge their risks.

This resurgence comes amid a period of relative market calm, with options-selling funds doubling their assets to $192 billion in the past four years. Today's short-vol trades, primarily involving call writing or covered calls, are seen as less leveraged and vulnerable compared to 2018, aiming to moderate losses while limiting upside potential. Analysts like Charlie McElligott of Nomura suggest that while these trades suppress implied volatility, they don't pose a systemic risk under the current market conditions.

However, concerns linger about investors being drawn to the attractive yields of these strategies without fully understanding the risks, potentially leading to significant disappointments. The VIX itself has been trending lower, indicating a period of market tranquility not seen since before the pandemic, with the S&P 500 ($.INX) reaching all-time highs. Yet, the MLIV Pulse respondents are cautious, with predictions for the VIX to average close to 20 or above this year, hinting at a possible market downturn.

In preparing for potential market declines, respondents are divided between utilizing derivatives strategies like buying S&P 500 puts or VIX calls and opting for Treasuries as a hedge. RBC Capital Markets' Amy Wu Silverman, however, notes the mixed success of option protection strategies in recent years, suggesting the market's resilience amid ongoing tech exuberance.

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