The Short Volatility Trade Implodes – A “2018 Flash Crash” Post-Mortem

After yesterday’s shocking implosion in the stock market, many US traders were no doubt surprised to see the sunrise this morning. All told, the widely-followed Dow Jones Industrial Average collapsed by 1,179 points, its largest ever drop in absolute point terms. At one point during the afternoon, the index shed 700 points in less than 5 minutes and was trading down nearly 1,600 points overall!

While the absolute point drop will garner all the headlines on the evening news, it’s worth noting that the move wasn’t nearly as dramatic on a percentage basis; yesterday’s 4.6% decline in the Dow was just the 108th worst decline in the index since 1900 (h/t Michael Batnick). Put another way, the stock market has, on average, seen a similar drop about once per year over the last 117 years.

Source: TradingView, Faraday Research

So what caused the big selloff?

In a complex adaptive system like a capital market, it’s impossible to identify a single catalyst for any market move, much less a dramatic collapse like the one we saw yesterday. That said, a number of factors combined to make the market particularly prone to an abrupt reversal:

Sentiment toward stocks was reaching euphoric levels, and the broad indexes were severely overbought. Indeed, the weekly relative strength index (RSI) recently hit its highest level ever.

Signs that US wage growth was finally perking up meant that the cost of hiring and retaining employees may hurt corporate profits moving forward.

Fixed income traders were increasingly convinced that the Fed would increase interest rates aggressively this year, driving up interest rates. This concern was exacerbated by fears of a “policy misstep” following this week’s leadership change atop the central bank.

The escalating political tension in the US following the release of the “Nunes Memo” raises the risk of a “constitutional crisis” (to say nothing of another impending government shutdown).