In a now-legendary interview given almost exactly one year ago, Artemis Capital’s Chris Cole appeared on the MacroVoices podcast to elaborate on a paper he had written titled the “Volatility and Alchemy of Risk”, where Cole laid the risks posed by what he estimated to be $2 trillion in global explicit and implicit short-volatility exposure, and how the unwinding of this massive position could usher in an era of instability across asset classes as markets were forced into a devastating reevaluation of systemic risk.
And as fate would have it, barely a week later on Feb. 5, markets exploded in a massive short-vol squeeze that vindicated Cole’s warnings and led to the death of one of the most popular short-vol ETPs – eroding years of profits accrued by amateur day traders who had reaped millions in profits off the short-vol trade.
Fortunately for legions of American retirees and retail investors, the February blowup proved to be an isolated incident. Markets staged a surprisingly swift recovery, and by the summer, had returned to all time highs. But Cole persisted with his warnings that what we saw in February was merely the weakest hands getting pushed out of the short-vol trade, and that more chaos would follow.
And so, with markets sloughing off a brutal fourth quarter, prompting some in the financial press to speculate about whether the bulls are back in charge, Cole is making his triumphant return to MacroVoices to offer his take on the volatility that gripped markets during the fourth quarter, along with a word to the wise: The unwind of the massive short-vol trade that Cole predicted more than a year ago isn’t over.
Rather, it’s just beginning.
But first, a quick refresher: In Cole’s view, traders have massively underestimated the risks associated with the short volatility trade by using it as a source of return and an input for taking risk. Counterintuitively, the more volatility goes down, the more risk rises. The more volatility goes up, the more risk is taken off. This sets up a regime of self-reflexivity that creates massive systemic risk.
I think what we saw last February actually just was the weak hand of the table being taken out by the short-vol trade. A lot of people read my paper. They came to me, and they said congratulations on getting it so right because there is this blowup of the short VIX ETP products …read more