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Retail Investors Withdraw Billions Amid Market Turmoil
Billions have been drained from retail investors, but the transactions have also caught the attention of hedge funds and pension plans. The bet that stock markets would remain stable has cost retail traders, hedge funds, and pension funds heavily following the global market crash driven by fears of an impending recession in the U.S., as reported by Reuters.
The CBOE VIX index, which measures market expectations for volatility based on the S&P 500, experienced its largest intraday spike and closed at its highest level since October 2020 on Monday.
Significant Losses in Volatility Bets
According to calculations by Reuters along with data from LSEG and Morningstar, investors in ten of the largest exchange-traded funds (ETFs) betting against volatility have erased $4.1 billion in returns from peaks reached earlier in the year. These were bets against volatility that yielded profits while the VIX, the most followed indicator of investor anxiety, remained low.
Options betting on volatility gained such popularity that banks, in their efforts to hedge the new business they were acquiring, may have contributed to market calmness before trading took a sudden downturn on August 5, according to investors and analysts.
The Scale of the Volatility Bet Market
While it’s challenging to measure the total amount of these bets, JPMorgan estimated in March that assets managed in publicly traded ETFs betting on short positions amounted to approximately $100 billion. “Just looking at the rate of change of the VIX on August 5 is enough to see the billions lost by those employing short volatility strategies,” remarked Larry McDonald, co-author of the book How to Listen When Markets Speak.
However, McDonald noted that publicly available data on ETF performance does not fully reflect the losses incurred by pension funds and hedge funds trading in private deals through banks.
Market Resilience and Short-Term Options
On Wednesday, the VIX rebounded to around 23 points, a significant drop from its Monday highs above 65 points, but it remained elevated compared to levels observed just a week prior. One of the drivers behind the popularity of trading strategies in recent years has been the rise of options that expire on the day they are traded—short-term capital options that allow traders to make 24-hour bets and collect all generated premiums.
Since 2022, investors, including hedge funds and retail traders, have been able to trade these contracts daily rather than weekly, offering more opportunities for short positions regarding volatility while the VIX remains low. For the first time, these contracts were included in ETFs in 2023.
Short-Term Bets and Covered Call Strategies
Many of these short-term options bets are based on covered call strategies. This involves selling call options while investing in securities, such as large-cap stocks in the U.S. As stock prices rise, these transactions yield premiums while market volatility remains low.
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Current Trends in Volatility Trading
The market has maintained a low volatility level, indicating a successful bet for investors. From January until July 1, the S&P 500 index surged by over 15%, while the VIX, a measure of market volatility, decreased by 7%.
Hedge Fund Strategies
According to two investors speaking to Reuters, some hedge funds have been taking on short volatility positions through more complex trading strategies.
A popular strategy among hedge funds has been to exploit the disparity between the low volatility of the S&P 500 and the individual stocks that approached historical highs in May, as highlighted in a study by Barclays during that period.
PivotalPath, a hedge fund research firm, monitors 25 funds trading in volatility, which collectively manage approximately $21.5 billion of the industry’s total assets, estimated at around $4 trillion.
Data shows that hedge funds generally tend to bet on an increase in the VIX. For instance, on August 5, they suffered a loss of 10%, while the broader group of hedge funds that engaged in both short and long volatility strategies saw returns between 5.5% and 6.5% on that same day, as calculated by PivotalPath.
Suppressed Volatility Dynamics
Banks play a crucial intermediary role in these trades on behalf of their larger clients. In their quarterly review from March, the Bank for International Settlements (BIS) suggested that banks’ hedging practices contribute to keeping Wall Street’s fear index low.
Post-2008 regulations have limited banks’ ability to hold risk, including volatility trades. When clients seek to trade price fluctuations, banks hedge these positions, as noted by the BIS. This process involves buying when the S&P decreases and selling when it rises, thereby dampening volatility through the actions of major dealers.
In addition to hedging, three sources have identified instances where banks hedged volatility-related positions by selling products that allowed them to balance their trades or maintain a neutral stance.
Complex Trading Structures
Marketing documents reviewed by Reuters reveal that Barclays, Goldman Sachs, and Bank of America have offered complex trading structures this year that included both short and long volatility positions.
Some of these strategies, according to the documents, lacked continuous hedging to protect against losses and instead employed periodic hedging. This approach may have left investors vulnerable to larger potential losses when the VIX spiked on August 5.
Barclays and Bank of America declined to comment on the matter, while Goldman Sachs did not immediately respond to a request for comment.
Market Behavior and Investor Sentiment
“When the markets are near their peaks, complacency tends to prevail, making it unsurprising that both retail and institutional investors were selling volatility for the premium,” said Michael Oliver Weinberg, a professor at Columbia University and special advisor at Tokyo University of Science.
“The cycle remains consistent. An external factor triggers market sell-offs. Those who held short positions will now face losses,” he added.
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