The Next Market Fad to Blow Up

Following the slowest month in a long time, with volatility being compressed again, I thought it was a good time to highlight an important underlying driver of markets these days: volatility.  Volatility (more importantly implied volatility) is measured and today is an actual asset class that you can “invest” in for diversification purposes.  A few hundred billion dollars has been invested in various algorithm driven systems like “market neutral,” “delta hedging” and direct volatility ETP’s.  Most of these systems are pure computer-calculated formulas that track things like volatility, momentum and cross-asset correlations to determine whether they should be buying or selling.  These are known as price-insensitive trading systems as there’s no assessment of value where a person is using judgement.  And there is now enough money in these funds to drive market prices for weeks.  It has had the effect over the past few years of creating periods of calm followed by chaos as these systems all flow to together: buy-buy-buy, reverse, sell-sell-sell!

The amount of money being traded in Volatility Index (VIX) ETP’s is having a suppressing effect on the VIX, leading computer algorithms to buy the market which then further suppresses the VIX.  It used to be that a rising stock market would lower implied volatility, but now lower vol is triggering buy signals and driving the market higher.  a It’s a scenario where the tail is now wagging the dog and a low VIX doesn’t necessarily mean what it used to.  You can read about it here.

And we know how market speculators love to overdo it.  The more this trend has held, the more money continues to chase after it.

Jesse Felder did a great job highlighting the potential effects of all of this “short volatility chasing” last week in a post on his blog.  You can read the post here.  If you’re participating in the investment markets (managing your own investments or someone else’s money), this is some pretty important stuff to understand since these strategies and fund flows largely dominate the markets these days.

Thanks for following!

-Nick