Investment bank issues warning about “dangerous” trend of shorting the fear index
One of the world's top investment banks has warned that financial markets are entering "dangerous" territory as investors eye up increasingly exotic products in the search for returns.
In a note to clients, entitled "dangerous yield chasing", the Bank of America Merrill Lynch (BoAML) today raised a "red flag" over the "worrisome trend" of investors selling volatility as they try to book gains in the low growth, low yield environment.
Selling volatility is a complicated trade which is fundamentally a bet that volatility as measured by the Vix – or fear index – will go down over the short-term. Data from US stock markets shows that short positions in Vix are running at an all-time high.
BoAML analysts think such expectations that volatility will decrease are "complacent", raising fears that if any one of a number of external shocks occurs, traders could be left licking their wounds, and market turbulence could be amplified because it will catch swathes of investors off-guard.
The Vix index (above, since 2004) has had a series of mini-spikes since the financial crisis
"Selling volatility … is now at an extreme level, with net speculative Vix exposure at all-time shorts," said BoAML's global rates and currencies research team.
"In our view, complacency combined with short volatility exposure could set up the market for a highly correlated sell-off on the next shock.
Read more: Low volatility can lead to market shocks
"While it is uncertain where the next shock will come from, we believe there are several possibilities. To name a few: A faster Fed hiking cycle than the market is expecting, US election uncertainty and turmoil in Italian banks."
The Vix index, which is a measure of expected movements – up or down – on the US S&P 500 index has been running at elevated levels over the past 12 months, with the most recent spike coming before the EU referendum.