Volatility, volatility, volatility

Yesterday I wrote to you about the nature of risk. Contrary to wider market sentiment, I see huge risk building up in the financial markets. Read yesterday’s piece to get up to speed.

What is risk?

In capitalism, a risk is something that would make you lose money. Sometimes you can see risks – e.g. a competitor making a better or cheaper product. Sometimes you can’t.

In skiing, the risk of going faster is a more serious injury. For a small business or an investor, the risk is that you get less money out than you put in.

Volatility is not risk.

Volatility is just a measurement of how much the price of an asset fluctuates.

Confusing the two has led to a massive increase in the risk of capital loss for investors.

The new stop loss

It takes something special to turn a bear market into a crash. In 1987, it was automated stop loss orders. These were designed to prevent major losses by having your computer automatically sell an asset if it fell to a certain price point. What this meant was that all the computers tried to sell all the same stocks, all at the same time, after a small shudder in the markets. This caused a much bigger crash.

Volatility is the new automated stop loss.


Like mortgages before 2008, volatility has been ‘securitised’, i.e. a product was created to allow you to bet on volatility going up, or down.

An index was created called the ‘VIX’ which measured ‘implied volatility’. Implied volatility isn’t what volatility actually is, but what investors think it’s going to be.

Then, an instrument was created called the XIV. This allowed you to bet on the movement of the VIX.

More specifically, this allowed investors to bet that volatility would go down. To use market terminology – they could ‘short volatility’. And once the turmoil of the financial crisis has died down, it did. And they made a lot of money.

Investors can smell profit like sharks can sense blood in the water.

A wave of people flocked to this new product. The global economy stabilised, the threat of banking collapses faded, and employment figures picked up. And so, volatility did decrease.

In tandem, the short volatility trade increased. By 2018, a huge amount of money – an estimated $600 billion – was betting that the VIX, the volatility Index which tracks the S and P 500, would stay low.

This is the first layer of the short volatility trade. The explicitly short volatility layer.

It was all going so well for ‘short vol’ investors, for a time.

Until, in February 2018, a small shudder in the markets became a much bigger spike. All the people betting on low volatility finally got burned. A small uptick in volatility forced them to sell or hedge their positions, and this exacerbated the issue. This turned a small fall into a much bigger one.

A swathe of investors, all buying and selling the same thing in unison? It’s Black Monday, 1987 all over again. My colleague Nick Hubble thinks he knows what’s going to trigger the next Black Monday. He’s been right before, and I suggest you read his work as soon as possible.

But the market survived. Buy the dip philosophy won the day, and the world’s major markets carried merrily on.

The Second Layer

The first layer of the short volatility trade which is threatening to turbo charge the next market downturn is reasonably clear and visible. People betting on the VIX to go down are explicitly short volatility.

There is a much larger amount of money which is implicitly short volatility.

That is, they have been betting on volatility going down without realising it.

It starts with something called ‘risk parity’.

There is a belief that when equities go down, bonds go up and vice-versa. This has led to the view that a portfolio which balances the two has lower risk. What do these portfolio’s use to measure risk? Surprise, surprise, it’s our old friend volatility again.

Because if the markets can’t see any risks, then there can’t be any out there…

So how does this relate to the short volatility trade?

As volatility falls, these funds can justify buying more equities. More equities means more reward. Great!

As volatility has fallen over the last decade, this has created a circular system. With each fall in volatility, these funds buy more equities. This smooths out the dips, further reducing volatility, and so on.

What this means is that as ‘risk’ (volatility) falls, risk (actual) is added to the portfolio.

But oh wait… Hold on a minute… What would happen if volatility were to rise? All these funds, which are estimated to total nearly $2 trillion, would have to make the reverse adjustment. Simultaneously.

Just think about that. $2 trillion worth of funds all making the same shift out of equities at the same time, because their volatility-based risk models tell them to.

Chris Cole, CFO and founder of Artemis describes what this is like.

“These strategies are a little like a barrel of nitroglycerine sitting in the office.

I could go to your offices – I don’t know where you guys are located – but I could sit there and say, oh, what’s in that barrel? These are beautiful office, but what’s in that barrel?

And you’re like, oh, it’s it a barrel of nitroglycerine.

I’m like, oh my god, what’s it doing there? That could blow up three city blocks!

And you’d be like, oh, it’s no big deal. The bank pays me to keep it here.

And I’m like, that’s terrifying. All it takes is a small fire for that thing to explode.

And you’d be like, oh, it’s no big deal. We’ve been adding to the stockpile of nitroglycerine for five years. It’s never gone off. What’s the big deal?

It takes a fire. It takes a fire. And when that fire starts, something else starts that fire. And when that fire spreads, it then spreads to the barrel of nitroglycerine. And then the nitroglycerine explodes, blowing up three city blocks.”

To repeat, a lower frequency of risk does not mean lower risk.

An illusion of safety can lead people to massively increase their risk taking.

For the skier, six days without a fall might be followed by a broken arm on the last day of the holiday.

For an investor, nine good years could be followed by their portfolio halving.

Investors today are so used to stable, rising markets. But like the turkey waiting for Thanksgiving, a long period of serenity is meaningless relative to what happens on that fourth Thursday of November.

The simultaneous de-risking of $2 trillion worth of money, held in funds which use risk parity, will mean that equities across the board are being sold in massive quantities, in unison.

These may be the most liquid shares out there, but even this could turn out to be an illusion, as buyers will be few and far between once they have seen what’s going on. The assumed liquidity could be just as much of a falsehood as the assumption of continued low volatility.

Those are the two main layers of the short volatility trade. 

If you want to know how to protect your wealth when this crash does come, click here.

Tomorrow I’ll reveal the final piece of the puzzle.

James Allen is back in the office today. He’s preparing to release some research on Thursday (2pm sharp) that he’s been working on for months. He’s got a way for investors to make huge gains, in very specific, uncorrelated opportunities.

To find out more, click here.

Many thanks,

Kit Winder
Capital & Conflict

Category: Economics

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