Short interest on the two predominate ETFs tracking the most important US equity indices has never been lower.
In fact, it continues to make new lows, likely lending support to the benchmarks and enabling a succession of record highs, which in turn squeezes out more shorts in a self-fulfilling prophecy.
The figure below, from JPMorgan, shows the trend. The inexorable trend.
“Short interest has been declining in a rather steady manner since the second quarter of 2023,” the bank’s Nikolaos Panigirtzoglou wrote, in a Thursday note.
If you’re a regular, longtime reader, you can doubtlessly recount, from memory, how these sorts of dynamics feed on themselves. Panigirtzoglou spelled it out.
“[The] steady flow support from the gradual covering of short positions has suppressed realized vol, creating additional space (for volatility targeting investors or investors with volatility based risk management frameworks ) to take bigger equity positions in notional terms,” he wrote. “In other words, the declining short interest over the past year in these two major ETFs has become the equivalent of an implicit short vol trade.”
Remember: Everyone’s running the same risk management model, conceptually speaking. Lower vol allows for greater exposure and vice versa. You deploy leverage into receding vol and cut exposure when vol rises. It’s the Charlie McElligott motto: “Volatility is the exposure toggle in modern market structure risk management.”
As Charlie put it in 2021, “Whether a discretionary/active manager on VaR, a risk-parity fund, a systematic CTA Trend fund with a specific vol target, a variable annuity with downside protection triggers [or] tactical allocation models from roboadvisors,” everyone’s operating under the same regime.
Panigirtzoglou added a caveat, which felt obligatory — perfunctory, if I may say so. “This implicit short vol trade looks rather extended by historical standards,” he said. That could “pos[e] a vulnerability to US equities in a scenario where negative news starts reversing the decline in short interest.”
