Short sellers bet on calm in US equities
As the S&P 500 nears its record high, traders are taking speculative positions on listed notes which will bear fruit if market volatility drops
Volatility in equity markets in the United States is near a record low and traders have loaded up on bets it has further to fall.
Short holdings on an exchange-traded note tracking the Chicago Board Options Exchange Volatility Index have reached a six-month high, essentially a bet that the volatility gauge will keep falling.
There are about 19 million shares of the iPath S&P 500 VIX Short-Term Futures ETN that have been borrowed and sold to speculation on declines, almost three times the level from early June, according to data compiled by Markit.
Volatility is disappearing from the equity market again as the Standard & Poor's 500 Index trades near a record high, bolstered by some easing in geopolitical tensions and speculation that the Federal Reserve will continue to support economic growth in the US.
As of Monday, the VIX had fallen in 10 of the previous 11 days, a sign of confidence in the bull market as investors resist paying up for insurance against future equity losses.
"It's pretty amazing how quickly volatility has washed out of the market," said Dan Deming, a managing director at Equity Armor Investments. "Over time, being short volatility has been a winner, but it seems like that's been a pretty crowded trade these days."
The iPath ETN, often known by its ticker VXX, has become one of the most-traded US securities as strategies based on volatility exploded in popularity. A daily average of 42.8 million shares changed hands over the past month, third only to the SPDR S&P 500 ETF Trust and iShares MSCI Emerging Markets exchange-traded funds.
Bets against volatility show traders are conditioned to expect turmoil in the stock market to be brief. In the five weeks to August 15, almost US$320 million was added to the VelocityShares Daily Inverse VIX Short Term ETN.
The S&P 500 last week rallied the most since April on bets the Federal Reserve will support the US economy even as it shows signs of gaining strength. Minutes from the central bank's July meeting released last week reinforced its commitment to supporting the recovery.
The US equity index has not closed up or down more than 1 per cent in the past two weeks. The VIX, which measures the cost of options on the S&P 500, has tumbled 33 per cent since the start of this month. It dropped 13 per cent last week to 11.47, less than three points from its record low.
"The Bernanke put has been replaced with the Yellen put," said Scott Maidel, an equity-derivatives money manager at Russell Investments. "Even though a classic correction may be in order, the belief is that the Fed will save the day."
About 47 per cent of shares outstanding on the VXX have been borrowed and sold to speculate on declines, according to data from Markit. It reached 70 per cent on August 15, the highest level since March, and up from 19 per cent in May.
The Fed's plan to pare back economic stimulus and the upcoming congressional mid-term elections may fuel bigger price swings in the coming months, according to Rocky Fishman, an equity derivatives strategist at Deutsche Bank.
"We don't see a return to the lows in volatility that we've seen this year, but at the same time do not foresee a prolonged period of materially higher volatility," Fishman said.
The most popular options on the VXX are ones betting on further declines in the note. January US$20 puts that expire next year and in 2016 have the highest ownership and bearish contracts make up nine of the 10 contracts with the most open interest.
The structure of the VIX futures market this year had also made it attractive for traders to bet on declining volatility, Deming said. Futures contracts expiring in the near term were more expensive than longer-dated ones on six instances this month, a situation known as backwardation. That is the highest frequency of such occurrences since March.
In each case, traders would aggressively short volatility products like the VXX the day the so-called term structure reverted back to contango, when contracts that expire sooner cost less than later months, Deming said.
"It's like the tipping point, a sign that the storm has passed," he said. "It's a barometer that gives volatility sellers confidence to come back in and get short volatility."