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.
"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.