"Equity markets have finally woken-up after a period of low volatility and complacency that had led to rapid gains", said James Knightley, chief worldwide economist at ING. That's all changed following Monday's rout, putting at risk an estimated US$2 trillion tied to the strategy and stoking concerns of wider repercussions.
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.
That spread is likely to adjust higher as funds who have become very comfortable in selling volatility in recent years take a more cautious view. And funds that have followed the strategy have attracted massive inflows. That fluctuation is known as the implied volatility. As its name indicates, this kind of volatility is implied by the price of the option. Those are moves that should be well within expectations for normal market behavior.
The Vix jumped 116% on Monday - its largest rise on record - as the Dow Jones Industrial Average fell 4.6% - the stock index's biggest fall in percentage terms since August 2011.
Hardly at all, judging by the VIX. Corrections occur about once a year on average. It rose Tuesday morning to over 50, the highest level since Aug 2015. 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. Those investors ran for the exits on Monday as they tried to cover their trades.
He concluded: "While the fall in global equity markets looks dramatic, it is no more dramatic than the record rises we have seen since the end of November". That's roughly the size of India's economy.
Dusaniwsky noted that with Credit Suisse (CSGN.S) announcing on Tuesday that it would terminate its XIV ETP fund, short sellers will have to buy back shares to cover their short positions on or before February 20th, the last day of trading for the product.
AQR, a hedge fund, says that so-called risk parity strategies alone hold about $70 billion in global equities. Low, or falling volatility regimes on the other hand, have seen significant gains in equities as investors have used such times to add exposure to risky assets. That could have implications for assets including and beyond stocks in the coming weeks and months.