NEW YORK (Reuters) - Thursday's sharp drop in U.S. stock prices highlights the risks taken on by investors who continue to bet that market volatility will remain subdued, but these kinds of shocks to the system, experts say, are unlikely to deter them from a very profitable trade.
Friday's recovery in stock prices limited the damage for investors who have bet against rising volatility.
The CBOE Volatility Index .VIX, better known as the VIX and the most widely followed barometer of expected near-term stock market volatility, rose to a six-week high on Thursday, as a selloff in technology stocks deepened.
VIX-linked exchange traded products (ETPs), VelocityShares Daily Inverse VIX Short-Term ETN (XIV.O) and ProShares Short VIX Short-Term Futures ETF (SVXY.P), which are designed to weaken when volatility of the S&P 500 goes up, fell as much as 15 percent on Thursday.
However, the two ETPs remain up more than 75 percent for the year and are unlikely to fall out of favor, market experts said.
"It used to be that people would pull back on a day like yesterday," said Matt Thompson co-head Of Volatility Group at Typhon Capital LLC, in Chicago.
"People still do that, but the net effect is there are more people coming in to sell these (volatility) spikes."
Investors have responded to the most recent bouts of stock market volatility by increasing bets that calm will return to markets in short order, said Anand Omprakash, director, equity and derivative strategy at BNP Paribas, in New York.
Commodity Futures Trading Commission positioning data through June 20, also show big speculators' net short position in VIX futures at a record 146,845 contracts.
Increased difficulty in finding investment yields across asset classes and a belief that central banks will keep a lid on market volatility have boosted interest in this strategy known as selling volatility.
"Even though the Fed has raised interest rates, finding yield is still very difficult. Equity markets are near all-time highs, equity earnings yield is not terribly high," said Omprakash, who added interest in these trades has broadened over the last decade.
Omprakash and analysts at other big banks have warned that heightened interest in volatility trading poses a risk where a sudden shock to stocks could be exacerbated by investors rushing to cover their short positions.
But any such shock would have to be a lot more sustained, they say.
"Just because volatility rises a little bit is not going to do anything. They (volatility sellers) really need to be challenged by a much bigger selloff in the S&P 500," said Ilya Feygin, managing director at WallachBeth Capital in New York.
Reporting by Saqib Iqbal Ahmed; editing by Daniel Bases