Since the Federal Reserve last month effectively paused their tightening program – markets have calmed considerably.
Thus – investors are back shorting volatility as they expect smoother days ahead.
Or – in other words – investors feel confident again to go back picking up nickels and dimes in front of a steam roller. . .
That’s because – as rogue economist Hyman Minsky taught us with his Financial Instability Hypothesis (FIH) – periods of complacency are the seeds for future turbulence. (And vice versa).
Thus – this peace and quiet is one of the biggest risks in the market today. And the longer it goes on for – the more violent the whiplash will be.
According to Bank of America Merrill Lynch (BofAML) – there’s exceptionally low volatility across many assets. (Further – I wrote a piece recently highlighting the extremely low implied volatility in currency markets).
Note that we haven’t’ seen such low levels of volatility across multiple assets since before the ‘vola-pocalypse’ in February 2018.
(The ‘vola-pocalypse’ was when Wall Street’s favorite trade – shorting volatility – suddenly blew up. Sending global markets into a frenzy).
It’s clear that shorting volatility has become a ‘crowded traded’ again (an asset class or investment theme that has attracted an unusually large number of market participants).
And I consider that a ‘tipping point’.
Because even a minor market ‘surprise’ (aka a black swan) in any one asset could send volatility surging across many assets. (Just as the chart above shows).
That’s because cross-asset correlations are extremely high today (because of algorithms and leverage).
Meaning: a sudden spike of volatility in Italian government bonds could cause a spike of volatility in U.S. equities or Chinese corporate bonds.
Now – to guess where and when the black swan will show up is the million-dollar question. And one that I don’t plan on trying to answer.
Instead, I will just take what I learned from both Minsky and the former-trader-turned-philosopher – Nassim Taleb – with his concept of ‘antifragility’ (to gain from disorder). And position for positive asymmetry (low risk, high reward) while I wait for a spike in turbulence.
Thus – rather than shorting volatility (which is already at very low levels) – I think betting on high volatility offers much better upside with less risk.
Or – putting it another way – I’d rather profit from the coming wave of high-volatility rather than being drowned by it.
Because – as we learned from Minsky’s FIH – periods of low volatility are the seeds for future high volatility. (And vice versa).
Therefore – at this time – it makes sense to take advantage of the crowd shorting low volatility. And go long assets that benefit from periods of high volatility and market turbulence.
Stay tuned.
