We can now add yet another entry to the long list of overly complex financial products that have been designed, built and levered before blowing up in investors' faces, writes Joseph Amato, president and chief investment officer for equities at Neuberger Berman.
For two years, equity markets kept going up and the best-known measure of implied market volatility - the CBOE Volatility Index, or VIX - seemed trapped, incredibly, below 10.
Inevitably, structured products were developed to sell VIX futures and pick up the premium from being 'short volatility'. Equally inevitably, the fact the VIX was so low and the premium so tight led to more and more leverage being applied.
These products were so far over their skis that a modest sell-off in equity markets was enough to push the VIX to levels that sent them crashing down the slopes.
Product providers had to buy futures to 'cover' their ruined shorts, pushing the VIX even higher and turning the entire levered short-volatility trade into a snowball. At one point, the VIX hit 50. Remarkable.
It looked very painful from the sidelines, but do those of us investing in the 'real economy' need to worry?
We don't think so.
In fact, we think the current environment offers great opportunity for selling volatility, as long as it remains unlevered. If I could, I would underline that last word three times in red.
Neuberger Berman runs strategies like this, which have the potential for enhanced index returns with around two-thirds of the volatility. They behaved as anticipated last week and, as long as implied volatility remains elevated, they get the chance to 'write' (that is, sell) put options for much higher premiums than a few weeks ago.
As my options-strategy colleagues put it: "The number one rule in options selling is to be humble with no (or very, very low) leverage, and not to get taken out."
For those of us who take equity risk in the equity markets themselves, it is worth remembering that the S&P 500 index finished January up nearly 6% and was overdue a correction.
Since the mid-2016 Brexit-driven sell-off, markets have risen 40% without so much as a blip. Markets never go up in a straight line, and every extended bull market has had meaningful corrections. While painful, these corrections are like taking a bit of bad-tasting medicine to maintain one's health.