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Hedge fund bets on a smooth market may backfire after going too far

Hedge funds have been betting on calm markets, and so far that trade has paid off. However, so many investors have made the same bet that several analysts worry the low market volatility can’t last much longer, resulting in a large market sell-off.

As measured by short interest in the iPath S&P 500 VIX Short-Term Futures exchange-traded note (VXX), bets against stock market swings have shot up to their highest on record.

The VXX tracks futures contracts for the CBOE Volatility Index (.VIX). The VIX is widely considered the best gauge of fear in the market and measures the buying of put and call options on the S&P 500 near-term options.

Record high short interest in this ETN means investors have borrowed, and then sold, an all-time high number of VXX shares in expectation they can buy them back cheaper later. In other words, they are making a record bet on blue skies for the market.

“The danger I see is when crowded trades like this unwind, you don’t go from just low volatility to just moderate volatility,” said Peter Atwater, president of Financial Insyghts and adjunct professor at the College of William and Mary.

Based on historical market behavior, “we’re going to see a period of extreme volatility now follow this,” he said.

Short interest in VXX over five years

Source: FactSet

Traders and bank executives alike have worried for months that persistently low market volatility signals something bad will come soon. U.S. stocks have held near all-time highs, but high-performing technology stocks began to sell off in the last several weeks. Major central banks have also indicated monetary policy may tighten soon, sending sovereign bond yields higher and pressuring stocks.

Once volatility picks up and the VXX starts climbing, “that’s the kindling out there that gets the fire really roaring,” Jon Najarian, co-founder of the Najarian Family Office, said Thursday on CNBC’s “Halftime Report.”

Najarian pointed out that more traders would buy VXX to protect against further volatility, sending the price higher. That rise would also force short sellers to cover, or buy back shares, resulting in further gains.

“If this doesn’t reverse here pretty quick, all those shorts that have bet against VXX are going to cause it to spike even higher,” Najarian said.

Volatility indexes on the rise

The VXX jumped more than 5 percent Thursday, after falling 19.2 percent in the second quarter, its seventh-straight quarterly decline. The VXX is down 75 percent over the last 12 months.

The more widely followed measure of volatility, the VIX, also rose Thursday, hitting 12.54, its highest since a week ago when it hit 15.16.

Like the VXX, the VIX has stayed low, hitting in early June a more than 23-year low of 9.37. That marked only one of 40 times the VIX has traded below 10 in its history, going back to 1990. Just over half, or 22, of those sub-10 trades, took place this year.

In mid-June, DoubleLine CEO and CIO Jeffrey Gundlach had already pointed out “a massive amount of money that is being short VIX.”

“It’s a trade that’s made a lot of money and it’s very, very crowded, which suggests to me the days of low volatility are numbered,” he said during a fund performance conference call. We “probably won’t see it continue through year-end.”

VIX net speculative position

Source: DoubleLine

To be sure, Goldman Sachs equity strategist Christian Mueller-Glissmann said in a late June report that while volatility may be disturbingly low, investors may miss out on market gains if they’re not invested. He noted that risky assets like stocks tend to rise during periods of low market volatility.

But increased talk of how so many are on one side of the low volatility trade could signal the wind is changing.

“What matters to me is the VIX trade is an incredible testament to investor complacency here and complacency never unwinds gracefully,” Atwater said.

“It is yet another example of how markets are discounting political risk here,” he said, adding that a seasonal drop in market participation in the summer also doesn’t bode well for those short volatility.

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