One of the Most Infamous Trades on Wall Street Is Roaring Back

(Bloomberg) — Forget the artificial-intelligence frenzy — the most-exciting trade on Wall Street right now might just be betting on boring.

As winners of the AI boom like Nvidia Corp. power benchmark stock gauges to record after record, a less remarked-upon phenomenon has been unfolding at the heart of the US market: Investors are sinking vast sums into strategies whose performance hinges on enduring equity calm.

Known as short-volatility bets, they were a key factor in the stock plunge of early 2018 when they wiped out in epic fashion. Now they’re back in a different guise — and at a much, much bigger scale.

Their new form largely takes the shape of ETFs that sell options on stocks or indexes in order to juice returns. Assets in such products have almost quadrupled in two years to a record $64 billion, data compiled by Global X ETFs show. Their 2018 short-vol counterparts — a small group of funds making direct bets on expected volatility — had only about $2.1 billion before they imploded.

Shorting volatility is an investing approach that can mint reliable profits, provided the market stays tranquil. But with the trade sucking up assets and major event risks like the US presidential election on the horizon, some investors are starting to get nervous.

“The short-vol trade and its impact is the most consistent question we have gotten this year,” said Chris Murphy, co-head of derivatives strategy at Susquehanna International Group. “Clients want to know how much of an impact it’s having on markets so they can structure their trades better. But we have seen cycles in the past like 2018 and 2020 where the short volatility trade grows until a big shock blows it up.”

The good news for worrywarts is that the structural difference of the new funds changes the calculus — the income ETFs are generally using options on top of a long stock position, meaning that $64 billion isn’t all wagering against equity swings. There’s also likely a higher bar for broad contagion than in 2018, since the US market has doubled from six years ago.

The bad news is that the positions — alongside a stack of less visible short-vol trades by institutional players — are suspected of suppressing stock swings, which invites yet more bets for calm in a feedback loop that could one day reverse. The strategies are also part of an explosive wider growth in derivatives that is introducing new unpredictability to the market.

‘Somebody Has to Sell’

The trading volume of US equity options surged to a record last year, propelled by a boom in transactions involving contracts that have zero days until expiration, known as 0DTE. That has enlarged the volatility market, because each derivative amounts to a bet on future price activity.

“There basically is a natural increased demand for options because retail is speculating using the short-dated lottery-ticket type of options,” said Vineer Bhansali, founder of volatility hedge fund LongTail Alpha LLC. “Somebody has to sell those options.”

That’s where many income ETFs come in. Rather than deliberately betting on market serenity like their short-vol predecessors, the strategies take advantage of the derivative demand, selling calls or puts to earn extra cash on an underlying equity portfolio. It usually means capping a fund’s potential upside, but assuming stocks stay calm the contracts expire worthless and the ETF walks away with a profit.

Industry growth in recent years has been remarkable, and it has mostly been driven by ETFs. At the end of 2019, there was about $7 billion in the category of derivative income funds, according to data compiled by Morningstar Direct, three-quarters of which was in mutual funds. By the end of last year there was $75 billion, almost 83% of it in ETFs.

But while the money involved looks bigger, derivatives specialists and volatility fund managers are so far brushing off the risk of another “Volmageddon,” as the 2018 selloff came to be known.

John Marshall, Goldman Sachs Group Inc.’s head of derivatives research, said the strategy tends to come under pressure only when the market rises sharply. Most of the cash is in so-called buy-write ETFs, which take a long stock position and sell call options for income. A big rally increases the chances those contracts will be in the money, obliging the seller to deliver the underlying security below the current trading price.

“It’s generally a strategy that is not under pressure when the market sells off,” Marshall said. “It’s less of a worry for a volatility spike.”

Before the 2018 blowup, Bhansali at LongTail correctly foresaw the threat from the growing short-vol trade. He reckons there’s little danger of a repeat because this boom is powered by canny traders simply meeting retail-investor demand for options, rather than making leveraged bets on volatility falling.

In other words, the short-vol exposure itself is not a destabilizing force, even if such bets…

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