Trillion dollar risk lurks if market volatility does not stop

Trillion dollar risk lurks if market volatility does not stop

US stocks plunged almost 8% in three trading days until Tuesday as an explosion in implied volatility readings prompted investors to dump equities on growing anxiety about overheating economies, inflation and rising borrowing rates.

The Vix index should reflect this in the coming days. However, if the options market comes under stress causing implied volatilities to spike, the stress can spill over into actual stock price volatility and cause downward pressure on stock prices. One of the big money-making trades on Wall Street since 2015 has been to sell volatility.

The most widely traded volatility indexes include the Chicago Board Options Exchange SPX Volatility Index - known as the VIX - for the S&P 500 Index. The markets were placid and traders were sanguine.

That rise took the index to a close of 37.32 on Monday, its highest level since 24 August 2015, which was the last time the Dow fell by 1,000 in a day during the flash crash. However, in late January the market started to decline slightly and implied volatility started to tick up.

"There have been plenty of warnings over the past few weeks that equities were overvalued and that USA stock markets in particular were overheating". So while Wall Street was devastated by a 508-point plunge in the Dow Jones industrials on October 19, 1987, a drop of that size today, while much smaller on a percentage basis, remains frightening. On Tuesday morning, the VIX spiked to over 50 percent.

Davide Silvestrini, EMEA Head of global quantitative and derivatives strategy at JP Morgan, said the sharp losses experienced by short vol strategies will likely lead to reduced volatility selling flows from institutional investors.

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Starting Sunday, "value" days for Magic Kingdom will cost $109 for adults and $103 for children, which represent a $2 increase. Disney tickets broke the $100 mark three years ago, when single-day Magic Kingdom prices were upped $4, from $99 to $105.

Although the washout was violent, it was extremely quick, and stock markets have bounced more than 5 percent off Tuesday's lows. They bring discipline and help keep Wall Street hubris in check.

It is important to put this correction in perspective.

Currency markets in particular, have largely remained unaffected by Monday's market moves, with traditional safe havens such as the Japanese yen and Swiss franc benefiting only marginally. Do all you can to understand what is happening as corrections unfold.

While markets have focused on leveraged exchange-traded notes as a guide to how large these bets are - Morgan Stanley strategists estimate these products lost about $3.4 billion in the selloff - investors believe the scale may be far bigger.

Steven C. Merrell is an investment adviser and partner at Monterey Private Wealth, Inc., in Monterey.

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