One of the most popular trades right now is like “picking up nickels in front of a steamroller”

Worth the risk?
Worth the risk?
Image: Reuters/Thomas Peter
We may earn a commission from links on this page.

The US stock market has been calmly cruising along for a long time—so long that traders are starting to take risks that seem a little crazy. One is a bet that markets will remain as unusually placid as they have been in recent months.

Analysts have been confounded by the lack of volatility—the VIX index, often called the market’s “fear gauge,” has been bumping around record lows this year. The VIX tracks stock options tied to the S&P 500 index; it’s a gauge of traders’ expectations for the range of prices they expect the index to trade in over the coming month.

Nobody knows exactly why markets have been so calm. Events like North Korea firing a missile over Japan could finally jolt markets, but so far even nuclear-armed saber-rattling between the US and North Korea has failed to shock traders out of their snooze for very long. A worry is that central banks have made conditions so accommodative that investors are overlooking things like growing debt loads and high valuations, in addition to geopolitical turmoil.

“If you can’t beat them, join them,” seems to be the operating theory. An exchange-traded fund that wagers on the VIX falling—that is, when volatility declines the fund’s price rises—has more than doubled over the past year. Gains in the fund—its ticker is SVXY—compare with a 12% gain in the S&P 500 and around 50% for Apple stock over the same time.

Betting on volatility has become increasingly popular, which is why market professionals are worried the strategy is becoming too crowded. In July, market bets based on the VIX made up about 9% of average daily volume of all ETFs and notes listed in the US, according to Bloomberg. This month, SVXY has been among the most popular ETFs, with about $875 million of cash flowing in, according to ETF.com.

Inverse VIX ETFs like SVXY can fall as much as 30% in a day when volatility picks up, according to Russell Rhoads, director of education for the CBOE Options Institute. In an interview on ETF.com, he said the strategy is like “picking up nickels in front of a steamroller.”

The inflows into inverse ETFs aren’t particularly worrying, but these funds should be used, if at all, only during “a very short time frame,” says Todd Rosenbluth, director of ETF and mutual fund research at CFRA. The longer investors own these funds, the greater the chance for losses, given the nature of volatility during normal times.

At least one brokerage has taken action to limit the potential damage. Interactive Brokers, which has both hedge funds and retail investors as clients, noted earlier this month that VIX products are at risk of large swings, especially given that VIX readings have been so abnormally low in August. It warned customers that it was”significantly” reducing the amount of money traders can borrow, known as margin, to place some VIX-related bets.

There are “a number of crowded” trades, and those that bet against volatility are perhaps the most worrying, according to Alberto Gallo, head of macro strategies at Algebris Investments. The firm pointed out in research earlier this year that prolonged low volatility doesn’t mean there’s less risk.

Too many risky VIX bets may just be a symptom of an even bigger problem: Many investors are making the same bets on a variety of assets—expecting the stock market to rise and for interest rates to remain low, for example. When a trade is crowded, the fallout can be severe when the momentum reverses, with unpredictable knock-on effects. It’s starting to look like betting on the markets to remain calm has become one of the riskiest trades.