- Short sellers targeting volatility were served a swift comeuppance earlier this year when price swings spiked by the most on record, decimating positions.
- Morgan Stanley warns that these traders haven't learned their lesson and that a similarly perilous situation is mounting.
- The firm also provides recommendations around where traders should be looking to get long volatility.
It has been said that repeating the same mistake and expecting a different result is a psychological fallacy.
If so, one group of investors missed the memo, because that group is once again heading down a dark path that led it astray mere months ago.
We're referring to volatility short sellers, who were caught off-guard by a market shock in early February that left them scrambling to cover positions, putting even more pressure on existing holders. That, in turn, wiped out billions from the values of the investment products used by those traders, with some dissolving entirely.
To say it was a disaster would be an understatement. Traders, who for months piggybacked off a placid market, reaping easy profits from short-volatility positions as stocks stood still, were jolted back to a reality filled with price swings.
Which is why it's so disappointing to hear that at least some of these investors are back up to their old tricks, gleefully shorting volatility as if nothing happened.
It's a development that has caught the eye of Morgan Stanley, which experienced some blowback from short-volatility enthusiasts earlier this year after it recommended that investors go long. To defend their call, the firm ran so-called stress tests to see how susceptible various asset classes are to a shock.
While not altogether surprising, the findings paint a gloomy picture ahead for those still shorting volatility.
Volatility stress test
Before we get into the results of Morgan Stanley's stress test, let's cover the ground rules.
First, the firm is defining a volatility "shock" as an instance when three-month implied volatility reverts to long-term averages. As previously mentioned, expectations of price swings were subdued throughout 2017, and they have only recently started showing signs of life.
Second, the firm is assessing a measure called "carry," which it defines as the gap between three-month implied volatility and its corresponding one-month realized measure. For the purposes of this exercise, carry is calculated in terms of how many months current levels need to persist for short sellers to absorb a shock.
In the end, Morgan Stanley discovered that current carry levels need to continue for more than five months in order for sellers of volatility to avoid a similar meltdown to the one in February.
"Equity, credit, G10 FX and rates need two quarters of current carry levels to be protected from mean-reversion in implied vols," Phanikiran Naraparaju, a strategist at Morgan Stanley, wrote in a client note. "This is the time needed to build up enough cushion to withstand a vol spike. Vol sellers don’t have enough runway."
Morgan Stanley recommendations
With all of that established, the question then becomes: If shorting volatility is such a fool's errand at this point, where should investors go long?
Morgan Stanley makes a handful of recommendations informed by the chart below, which plots assets based on the percentile of their three-month implied volatility. As you can see, all of the firm's suggestions deal with assets whose past price swings are in the 30% percentile or lower.
Here they are, with all quotes attributable to Naraparaju and his colleagues:
1) Buy 50-day puts on CDX HY (high-yield credit-default swaps)
"Breakeven relative to spot is just a 3pts decline in CDX HY ... HY credit has been realizing well and carry is fairly low"
2) Buy 40-day USDJPY (US dollar-yen) puts expiring in one year
It's "a way to protect against USD reversal" ... "Although JPY vol carry is very positive, the unusually low levels of current implied vols mean the vol reversion also quite large."
3) Buy Nikkei 30-day puts expiring in six months
"We like positioning for a stronger JPY and weaker Japan equities with Nikkei 6m 30D puts ... The volatility unwind of early February, followed by Fed hawkishness and trade concerns, has compressed the vol spread between Japan and Europe versus S&P 500, making Japan equity vol attractive to own."
4) Buy long-dated calls on brent crude
"We think that both the spot and vol curve favor buying long-dated calls."
5) Buy USD 3m10y receivers
"Our rates strategists believe that Treasury yield duration will end the year lower than 3%. Duration short positioning in CFTC futures is at record levels, making yields vulnerable to sharp declines on unwind."
