March 9, 2018 / 10:13 PM / 2 months ago

Derivatives experts wary about next U.S. stock volatility shock

BONITA SPRINGS, Fla. (Reuters) - Investors should be protecting against secondary shocks as the initial surprise of a February plunge in U.S. equity markets wears off, analysts warned on Friday.

The recent bout of volatility rocked a market that had been unusually calm by historical standards, leaving investors used to a steady march higher in stock prices wondering how to best position themselves.

“Is this it? Or is this symptomatic of something much, much larger?,” asked Dean Curnutt, chief executive of Macro Risk Advisors, in a keynote speech at the Cboe Risk Management conference.

“I would argue that it is an open question, but it’s something we should be really thinking about,” he said.

A 4 percent drop in the benchmark S&P 500 index .SPX on Feb. 5 triggered the largest-ever spike in the Cboe Volatility Index .VIX, a barometer of expected near-term volatility for U.S. stocks known as Wall Street's "fear gauge."

The shock upended the index from record lows that had spawned massive interest in so-called short volatility trades, causing several popular VIX-linked short-volatility exchange traded products to implode.

Investors are now looking for ways to transition to a more normal level of daily price swings or even a period of above-average volatility.

One approach would be through longer maturity derivative contracts, such as VIX futures and call options, that would offer protection against rising volatility, Nitin Saksena, head of U.S. equity derivatives research at Bank of America Merrill Lynch, told Reuters.

Recent stock market ructions have made hedging with S&P 500 options expensive, so investors could also look at owning proxy hedges like protective options contracts on the Euro Stoxx 50, FTSE and Russell 2000 Index, he said.

Single-stock options also offer an alternative for investors looking to hedge equity-related portfolios, said Kambiz Kazemi, partner at Canadian investment management firm La Financière Constance.

“The markets have entered a new regime and will likely experience more bouts of volatility and be tested in the medium term,” Kazemi told Reuters, pointing to political uncertainty and the prospect of higher U.S. interest rates.

Large and opaque risks from trend-following strategies, risk-parity portfolios and volatility-targeting funds, all plays on low volatility, could still linger in the market.

There is little consensus among analysts on exactly how much money is devoted to these types of strategies, but many agree it is substantial.

Some $1.5 trillion had been involved in strategies linked to short volatility, according to a November paper by Vineer Bhansali, chief investment officer at California-based investment adviser LongTail Alpha. bit.ly/2p08QjT

Kazemi is not particularly bearish right now, he told Reuters, but there may be lingering risk from short volatility positioning and product design that is not fully appreciated in the market.

To be sure, these strategies have diverse time horizons and exposures and may not unwind at the same time, making a repeat of the recent short volatility implosion unlikely, analysts said.

But depending on how the strategies react, there is a possibility that “it will not be a pretty unwind,” Kazemi said.

    Reporting by Saqib Iqbal Ahmed; Editing by Daniel Bases and Meredith Mazzilli

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