Chris Cole has that odd, angular perspective on the world that is often correlated with derivatives traders. Such a perspective tends to look beyond the obvious direction of the underlying asset but rather considers how quickly and expansively that price movement occurs. They look for contract structure mismatches and points when time decay premium is either under or overpriced. Cole, for his part, looks at the short volatility phenomena as the height of financial engineering and has resulted in “the Ouroboros,” a form of alchemy that creates something from nothing and fills believers with delusion, Cole believes. This “dangerous feedback loop” that is currently painting a lovely tranquil picture – much like 1987 – but it ultimately leads to the snake eating its own tail because its mind is clouded into thinking that is appropriate food. This is the short volatility conundrum.
The professional derivatives trader, who looks at all angles for opportunity price mismatches, typically has an interesting view of the world. Such a view is visible through a number of Cole’s numerous market tomes he publishes from his website. In an October missive, “Volatility and the Alchemy of Risk: Reflexivity in the Shadows of Black Monday 1987,” the Austin, TX-based researcher and fund manager looks at the world and sees it as one overleveraged short volatility play. But is the outlook actually underestimating the risk and predominance of short volatility exposure throughout the world? In a world where market calm has created odd market correlations, could the storm of the decade be on the horizon?
In many respects, the macro picture painted in 1987 isn’t that much different than today. Coming into October 1987, the economy was painting a deceptively placid picture. Stocks were booming, the economy was expanding and interest rates were rising. “Portfolio insurance,” another way of saying “short volatility,” was predominate and computerized “program trading” would without human logic or concern for the market structure implications piled on the sell side when a trend was detected.
How is this any different than today?
The primary difference is that the “portfolio insurance” business has grown significantly and it all has one commonality.
“A short volatility risk derives small incremental gains on the assumption of stability in exchange for a substantial loss in the event of change,” Cole wrote, defining the returns streams of many investments with asymmetric payoff characteristics.
But does it go far enough?
The global short volatility trade, now estimated at $2 trillion, could actually be much larger depending on how one categorizes the trading tactic exposed to sharp and expansive price movements.
If one is to define short volatility by the mind-numbing, unhedged strategy of short selling options in a non-directional fashion and embracing the retail-focused and highly leveraged XIV or UVXY exchange traded funds, the short volatility might just be that limited.
Cole, for his part, engages in a more extensive accounting of both explicit and implicit short volatility risk. From his standpoint, the headline-grabbing short volatility exchange-traded funds are just the start. “Despite the headlines, this is the smallest portion of the short volatility trade,” he writes.
Explicit short volatility has $60 billion in assets by Cole’s account, including $45 billion in pension fund option writing strategies. But implicit short volatility strategies, which don’t directly sell options but rather use financial engineering to generate short option like risk, is even more significant. He looks at as much as $1.42 trillion in exposure, including up to $600 billion in risk parity strategies, which in part are defined by their leverage adjustment trigger based on volatility. “These strategies are similar to a short option position because they produce efficient gains most of the time, but are subject to non-linear losses based on variance, gamma, rates, or correlation change,” Cole writes.
But why stop there?
If the definition is expanded to include all trading strategies that are exposed to sharp price moves, collect low but consistent premium payments but have significant far left tail risk, then the global risk exposure might include many bank OTC derivatives positions and encompass over $300 trillion in exposure, with a significant amount correlated with interest rates and related currency values.
Short volatility is all around us. The issue is how it is hedged. This was the topic of a recent Greenwich Associates report acknowledged the bank’s largely short volatility derivatives writing practices in a September 2017 report. The primary argument was that OTC derivatives risk should not be recognized by regulators for capital charges to the same degree when they are hedged with offsetting listed derivatives. In fact, the big banks, it could be said, have the largest exposure to short volatility in the world.
The short volatility threat that currently underlies the economy is more of a systematic problem, one with numerous hidden risks. Cole, for his part, recommends a long volatility approach to the world, a viewpoint embraced by hedge funds and institutional investors who have been gobbling up hedges and long volatility strategies in droves. The trick, of course, is finding the right long volatility play that defends portfolios when the ultimate market crash occurs but not paying too much for it as markets rise. Finding this balance might just be about recognizing mispricing in volatility as much as it is taking a viewpoint on the direction of markets.
Read Cole's full piece here.