We and others have variously described the extent which changes in market structure and central bank intervention (whether through word or deed) have conspired to ensure that vol. spikes rapidly “mean” revert.
The increasing rapidity with which intermittent flareups collapse has been a defining feature of markets over the past couple of years and this dynamic has become especially prevalent since Brexit.
“Shares outstanding in the short vol ETPs tend to increase following a volatility spike as investors rush to capitalize on the increase in vol.,” Deutsche Bank wrote earlier this week, adding that “an initial spike in volatility will see short vol traders reengage and unless the vol spike ‘sticks’ we can expect the old behavior to continue.”
Of course vol. spikes cannot “stick.” Because the interaction between the BTFD mentality and the central bank “put” that makes that mentality a virtually infallible “strategy” serves to optimize around the prevailing dynamic making change all but impossible.
“The nature of volatility since 2014 has entirely changed, with volatility shocks retracing at record speed,” BofAML writes in a note dated Wednesday. Have a look at the following chart:
And here’s another underscoring the same point:
That said, the technical risk inherent in the VIX ETP rebalance (vega-to-buy on an N-vol. spike) and the possibility of that rebalance exacerbating the initial spike and forcing an unwind in vol.-sensitive systematic strats means that an inherent instability lies seething beneath an outwardly stable situation. It’s Kocic’s “metastability.” At heart, it’s fragility (as explicitly noted in the first chart shown above).
But until such a time as the dynamic changes, the status quo prevails. As BofAML describes it, “investors no longer fear shocks, but love them, as it is an opportunity to predictably generate alpha.”
Such is the world we live in.