Note: This blog post was also posted in Seeking Alpha on 8/12/19.
The market is bouncing wildly, and that should make Mom and Pop investors pause and take note. The S&P 500 hit new highs in mid-July, reaching 3,000. Then on Monday, it had its worst day of the year, losing 3% to close trading at 2,844. The broad stock market is jumping on a slew of news, from the Fed’s recent cut in interest rates to President Trump’s threats of fresh tariffs on China.
Investors need to beware such bursts of volatility, particularly as wide swings in the market have been uncommon during the historic 10-year rise of the market that began in March 2009.
According to investor website Investopedia, when the stock market rises and falls more than one percent over a sustained period of time, it is called a “volatile” market. And market volatility can be seen through the VIX or the CBOE Volatility Index.
Indeed, the broad market and retail investors could be headed for a “VIX-plosion,” according to a recent CNBC article.
The VIX, which is known as the stock market’s fear gauge, has been sitting at relatively low levels as stocks hit all-time highs, CNBC noted.
But while muted market fears might seem advantageous for now, the VIX could effectively be a ticking time bomb, according to Sven Henrich, founder and lead market strategist at NorthmanTrader, a closely watched market analyst.
“It’s compressing tighter and tighter, and it’s building up this pattern,” Henrich said. “So, it’s ready for another breakout. The question is the when and the how.”
When the VIX rises, it tends to mean investors are growing concerned about the market and making bets to protect themselves, according to the CNBC article. Investors simply may not be prepared for the swings that could occur.
In the wake of recent market volatility, the “when and how” might be right now.
So where does this leave short volatility investors such as customers of UBS’s Yield Enhancement Strategy, known as YES?
This blog previously reported on investors who have claims against UBS for unsuitable investment recommendations and misrepresentation in the sale of the YES options trading strategy. The YES strategy was a “short volatility” options overlay on generally conservative portfolios – think of municipal bonds or cash. It was designed to increase yield during periods of low volatility.
Clients were required to put up collateral – called a mandate – that they were willing to commit to the strategy. Unfortunately, with the extreme volatility experienced in the market in November and December 2018, the YES strategy backfired resulting in investor losses of over 20%.
Many clients were forced to put up additional collateral and incurred substantial losses in a purportedly conservative and low risk strategy.
Our concern is that, in the light of the recent market’s gyrations, extreme volatility may be the new normal. That means UBS YES investors and other so-called “short volatility” investors could experience even more losses.