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Betting on calm may worsen the storm

marketsNEW YORK--The dog days of summer turn out to have quite a bite, as investors have been roiled by the longest bout of volatility in U.S. equities in four years.

The CBOE Volatility Index, the market's favoured measure of the degree to which investors expect securities prices to fluctuate, jumped 25 points to 53.29 in late August, the highest since January 2009. The VVIX Index, which measures the cost of hedging with VIX options, shot to an all-time high of 212.22.

Higher expectations for wider price swings create anxiety for investors, and many have responded the same way they did to the several fleeting spikes in volatility over the last three years - with big bets that calm will prevail in short order. That may not happen quickly, though.

A combination of nerve-wracking events - weak data out of China, uncertainty over the Federal Reserve's plans for raising interest rates, and leveraged bets by hedge funds that went the wrong way resulted in an intense level of selling that hit a peak with a 1,000-point drop in the Dow Jones Industrial Average on August 24. Markets seemed to quiet down after that, but Friday's renewed declines following the U.S. jobs report show that investors are still on edge.

The intensity of the shock may have upset the cart for many funds that use volatility strategies, and set off billions of dollars worth of portfolio sales that could delay the return of normalcy. Furthermore, a record number of bettors on lower volatility using exchange-traded products could find themselves in a losing position should events set off additional rounds of selling.

"I think we have moved into a new volatility regime," said Peter Cecchini, chief market strategist at Cantor Fitzgerald. "And it's likely not to reverse any time soon."

Some of the selling was triggered by so-called risk parity funds, such as Bridgewater Associates' All-Weather fund, and other funds that use what's known as "volatility control" mechanisms, designed to achieve a constant level of volatility in the markets. These funds also frequently use leverage, or borrowed money - so when volatility spikes, they respond with dramatic selling.

J.P. Morgan Chase strategist Marko Kolanovic estimates that the selling from these funds could total $100 billion over the next three weeks. That could keep volatility on the boil. Target volatility funds sold $156 billion of equities during the sell-off, according to Barclays Capital estimates.

If that happens, the investors that would be exposed are the ones who jumped into exchange-traded products that bet on a decline in volatility, also known as "short vol" products. Net short bets in these products hit a record of $2.5 billion in August, according to Janus Capital Group, the largest monthly net short flow into exchange-traded products the firm has seen, it said.

"History tells us that while some vol events are short-lived, it may be many months before we see a reversion in volatility," said Nick Cherney, head of exchange traded products at Janus Capital Group. "Going all in short volatility with the expectation of a quick reversion may prove costly."

Shorting volatility, essentially selling insurance to a panicked market, has been the go-to strategy for investors looking to profit from volatility. In this instance, however, betting on calm could have the opposite effect. "They may serve a role in exacerbating the volatility situation," said Cecchini.

If this were to happen, it would not be without precedent. "This is one of the factors that helped create large volatility spikes in late 2008 and 2009," Eric Heltemes, portfolio manager at Marquette Partners in Chicago, said. "Speculators tried to sell volatility too early in the selloff and were forced to panic buy it back as the market continued moving lower."

Investors are keeping a close eye on the S&P 500, and the 1,867 level touched on August 24. Should it fall through that level, more selling could be ignited. In correction phases like this, some expect a "test" of those low levels before markets are able to move higher.

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