In a now-legendary interview given almost exactly one year ago, Artemis Capital’s Chris Cole appeared on the MacroVoices podcast to elaborate on a paper he had written titled the “Volatility and Alchemy of Risk”, where Cole laid the risks posed by what he estimated to be $2 trillion in global explicit and implicit short-volatility exposure, and how the unwinding of this massive position could usher in an era of instability across asset classes as markets were forced into a devastating reevaluation of systemic risk.
And as fate would have it, barely a week later on Feb. 5, markets exploded in a massive short-vol squeeze that vindicated Cole’s warnings and led to the death of one of the most popular short-vol ETPs – eroding years of profits accrued by amateur day traders who had reaped millions in profits off the short-vol trade.
Fortunately for legions of American retirees and retail investors, the February blowup proved to be an isolated incident. Markets staged a surprisingly swift recovery, and by the summer, had returned to all time highs. But Cole persisted with his warnings that what we saw in February was merely the weakest hands getting pushed out of the short-vol trade, and that more chaos would follow.
And so, with markets sloughing off a brutal fourth quarter, prompting some in the financial press to speculate about whether the bulls are back in charge, Cole is making his triumphant return to MacroVoices to offer his take on the volatility that gripped markets during the fourth quarter, along with a word to the wise: The unwind of the massive short-vol trade that Cole predicted more than a year ago isn’t over.
Rather, it’s just beginning.
But first, a quick refresher: In Cole’s view, traders have massively underestimated the risks associated with the short volatility trade by using it as a source of return and an input for taking risk. Counterintuitively, the more volatility goes down, the more risk rises. The more volatility goes up, the more risk is taken off. This sets up a regime of self-reflexivity that creates massive systemic risk.
I think what we saw last February actually just was the weak hand of the table being taken out by the short-vol trade. A lot of people read my paper. They came to me, and they said congratulations on getting it so right because there is this blowup of the short VIX ETP products that occurred, actually, literally within a couple of days after the interview.
And I said, you know what, that’s not what I was referring to. Those short-vol products, those VIX ETPs, the weak hands of the table, that was just the first phase of what is going to be a multi-year cycle and rebalance in the vol regime as many of these institutional short volatility strategies come unwound.
Looking back to the beginning of last year, Cole touches on one aspect of the vol-pocalypse that has been widely misunderstood: That rather than being an “all at once” volatility explosion, volatility as measured by the absolute move in fixed strike volatility options on the S&P 500, actually rose more in January than it did in February, suggesting that the first rumblings of the February vol explosion could be felt weeks before.
Cole followed that up with a step-by-step analysis of how a repricing in interest rates led to a liquidity crisis that ultimately drove the blowup in equities.
Yeah, I think 99% of the people would say February volatility rose more. Actually, if you look at the absolute move in implied vol, fixed strike vols of the S&P 500, vol actually moved more in January than it moved in February of last year. A lot of that was actually right-tail movement in volatility. I think that is quite shocking to most people. The bond spike in February was widely misunderstood. The media talked about this as a volatility event. But this was not a true vol event.
It was a liquidity crisis as a result of a rapid repricing and tail risk. You had a lot of very weak hands at the table that were shorting volatility in the form of these VIX ETPs on the expectation of continued stability. And it was, put quite simply, there was a point where many of these strategies had never been tested in a true volatile environment.
And when we had a revaluation, volatility higher. These weak hands at the table were taken out. And what we saw, actually, was not a fundamental repricing in vol driven by the credit cycle or fundamentals as much as it was the weakest hands at the table scrambling to buy tail risk insurance. Not to hedge their portfolios. To hedge their careers. They were forced to buy tail risk insurance or face insolvency. This is analogous to some of the subprime lenders that blew out in the late 2006–2007, the dumb, dumb, dumb money that was over-levered and was out of control and got taken out early. Of course that dumb money gets taken out first.
There is an initial panic. And then we begin to see a fundamental regime shift in volatility that comes later, after that dumb money is taken out. This is what we’ve begun to see in the fourth quarter of 2018 heading into this year. And my point here is that, in February, traders were not buying options because they thought volatility would increase. They were buying options because they were facing insolvency. And that bid on tail risk insurance is what caused the vol in the VIX to shoot up so dramatically.
Ultimately, the chaos from February was largely contained within the VIX ETP space, which represents only a sliver of the overall $2 trillion monster short-vol trade…which means there’s still $1.95 trillion that Cole expects will unwind over the next 1-3 years.
In other words, “the Big one” – a blowup on par with Black Monday – could be in the offing,
And it was a blowout of this teeny portion of the global short vol trade. I talk about this Ouroborus, $2 trillion worth of short-vol exposure. These VIX ETPs were only about $5 billion – $5 billion of $2 trillion. We still have the much larger $2 trillion unwind in the global short-vol trade that has just begun to start. And this is a fundamental regime shift in volatility that, if history is any guide, will last anywhere between one to three years and presents tremendous opportunity for different strategies that profit from change and coincides with not only quantitative tightening but also the evolution of the debt and leverage cycle.
Particularly if resurgent inflation forces the Federal Reserve to keep hiking interest rates. Cole argues that signs of these stressors are already appearing in the form of rising interbank lending rates and widening credit spreads. These risks have been amplified by the record levels of corporate debt that is only one notch above speculative grade – creating the potential for a wave of newly minted fallen angels to produce a reaction that blows up the entire market…
Indeed, Black Monday 1987, most people think about the one day where the stock market dropped 20%. They don’t think about the fact that in early 1987 inflation was actually lower than where it is today and how rates shot up 300 basis points.
And that caused liquidity seize-up that initially started to show through in interbank lending and higher credit spread, then spread to a 20% drawdown in equity markets, all before Black Monday occurred.
…a process that Cole likened to a fire setting off a barrel of nitroglycerine…
So I like to sort of point out this idea that these short-vol strategies and these institutional strategies – many institutions seeking to use financial engineering to apply leverage to get extra yield because they’re not getting it on their fixed income portfolio – 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.
We couln’t have put it better ourselves.
Listen to the full interview below:
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