Market volatility has gone through the roof. Here's why that matters

Getty Images  Mario Tama

When stock market volatility ticks up, the funds would likely need to decrease their stock holdings in order to manage the risk.

The S&P 500 index recorded its biggest daily drop in over six years on Monday, and the VIX index shot up to its highest level since August 2015, breaking out of a historically low range.

With short-volatility ETPs, such as VelocityShares Daily Inverse VIX Short-Term ETN (XIV.P), the ProShares Short VIX Short-Term Futures ETF (SVXY.P), and VelocityShares Daily Inverse VIX Medium-Term ETN (ZIV.O), all logging massive losses, traders who had bearish bets against these products have much to be happy about. As the following chart shows, the drop that followed across the globe wiped out $4 trillion in world stock market capitalization, and world stocks have reversed their 2018 gains. A reading above 20 exceeds that of the volatility gauge's historical average, and may indicate a more bearish outlook for equities.

The "fear index" rose a further 7% to 39.94.

Does this represent a turning point in the global equity bull run, or merely a shift from a low-volatility to high-volatility regime?

Second, there is implied volatility.

If you own a VIX-related exchange-traded product, certainly.

At the root of the selling are concerns over inflation and rising interest rates, which have pushed up bond yields at the expense of stocks.

AQR, a hedge fund, says that so-called risk parity strategies alone hold about $70 billion in global equities. While its average level since 1990 has been 19.3, during the past three years that number has been close to 14. There's also MOVE for the US Treasury bond market.

Dusaniwsky said this could lead to higher volatility for XIV over the next few days as traders look to buy XIV to cover their short position. Barclays said there are now around $350 billion of assets under management in this type of strategy.

"The party may be over for now but this could be more of a sobering correction than a rout", said Jacob Deppe, head of trading at Infinox.

And that has large implications for other asset classes, namely fixed income and currencies where low volatility has been a principal driver of large returns. Implied volatility is a key component of option pricing.

Hans Redeker, global head of currency strategy at Morgan Stanley in London said though the initial focus of these funds have been in the U.S, commodity-linked currencies such as the Australian dollar and the Canadian currency which have been the focus of global macro funds will come under pressure thanks to worsening fundamentals.

Q: The recent drop in the stock market makes me very nervous.