What now? Volatility is key

The equity market sell-off that began in the US has continued through the Asian Pacific session overnight and carried on into the European open. Not only that, but US stock index futures are all lower again this morning adding to last night’s substantial losses. The Dow posted its biggest ever one day loss in points terms while the S&P recorded its worst day since 2012.

The size of the sell-off has shocked many investors coming as it has on the back of what appeared to be a never-ending stock market rally. But there’s been an element of markets losing touch with reality – particularly since the beginning of this year – and what we’re experiencing now is the major indices hitting the equivalent of an air pocket.

Of course, the question is: what now? The attitude of the vast majority of analysts is “don’t panic – this is only a correction, so use it as a buying opportunity.” Well that seems reasonable. After all, buying the dips has proved to be a guaranteed way to make money in the past, so why not now?

One reason may be the breakdown in the leveraged short volatility trade. This is where investors have bet on stock market volatility forever heading lower as global equities hit fresh record highs. Investors and speculators have increasingly employed leverage to get more gearing on this trade and now it has unravelled at breath-taking speed as volatility has spiked higher.

The danger is that as unhedged sellers of volatility struggle to pay their margin calls, they are forced to liquidate other assets. This in turn would put further selling pressure on equities. So it may be a tad soon to look to “buy the dip” unless you have the stomach to handle another lurch lower.