We started 2018 with a strong move in U.S. equities, continuing the up trend seen over the last twelve months. Something we didn’t experience very much of in 2017 that’s raised its ugly head over the last week is volatility, a topic I have a great deal of interest in, receiving the Charles H. Dow award for my research on market volatility last Spring. On Friday February 2nd we saw the start to a pickup in volatility, which often rises when stocks decline; which worsened on Monday February 5th as the Dow at one point declined 1,500 points. An investment strategy that grew tremendously in popularity last year was shorting volatility, making a bet that the Volatility Index would decline or stay at very low levels, which was a quite profitable strategy for a period of time – one that we at FEG capitalized on a few times throughout the year in a few of our investment models. In fact, inflows into short volatility Exchange Traded Products hit a new high last Wednesday of $1.35 billion according to Bianco Research – a sign of very high sentiment as investors piled onto just one side of the proverbial financial market teeter-totter.
As history has taught us time and time again, there is no such thing as a free lunch! And on Monday as Volatility began to spike higher as equities weakened, the short volatility strategy and certain investment products that used it began a practically waterfall-like decline. What was once considered a cheap, if not free, lunch all of a sudden became extremely expensive! The Volatility Index rose just over 100%, the largest single day increase since Black Monday in 1987, exceeding even what we saw during the financial crisis in 2008. However, the largest moves appear to be focused on volatility, while equities also were in a decline they were nowhere near as impacted as what was going on in the volatility market.
One specific ETF began to fall 50+% in after-hours trading. The specific causes for the massive decline in the product are still just rumors and go much further down the technical rabbit hole than we’ll go in to for the purposes of this note. The impact by these short volatility products exacerbated the rise in overall market volatility and amplified the losses seen by numerous investors, many of which likely didn’t fully understand the product that they purchased in their investment account.
This amplifies the importance of truly knowing what you own and why you own it. With the growing proliferation of investment options and products, understanding the internal mechanics of how they work and what their weakness are is vital. While seeing spikes in the Volatility Index is nothing new for the market, and have been a common occurrence to varying degrees throughout the long-term bull market, what we experienced earlier in the week will in fact go down in market history. Many investors and professional money managers are still learning how to properly understanding volatility. In fact I’ll be a guest speaker at the University of Chicago next week to speak with MBA students and other investment professionals, discussing the volatility market and methods for proper risk management. There’s much to be learned about this market tool, fortunately at FEG we have a good grasp on how to measure it and often take precautions against it.
Disclaimer: Do not construe anything written in this post or this blog in its entirety as a recommendation, research, or an offer to buy or sell any securities. Everything in this post is meant for educational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in the blog. Please see my Disclosure page for full disclaimer.