Over the past two weeks we observed two curious, vol-related phenomena.

First, it was Tom DeMark cautioning that even as stocks have surged, the amount of VXX shares outstanding has soared to record highs, a seemingly contradictory confluence of events because it suggested that investors, traditionally "going with the market flow", are betting on a major vol reversal and furthermore the move contradicts historical shifts in VXX holdings at times of extreme market upside.

Second, just days later, Goldman confirmed as much when looking at overall market volatility, admitted that "our view that the VIX may remain low in the near term is at odds with the VIX ETP market, as investors seem to be pouring money into levered long VIX ETPs." Goldman's derivatives team also wrote that "while long ETP exposure has been growing, the appetite for inverse VIX ETPs, which benefit from declines in volatility such as the XIV and SVXY, has been muted, with vega exposure remaining range-bound in recent weeks. That’s surprising, since the benchmark index which these underliers track (SPVXSPI) is up 73% since the market low on February 11 and investors often follow performance!"

Goldman's punchline: "Vega exposure on longs has tripled since February 11: The total amount of vega exposure across four popular long VIX ETPs (VXX, VIXY, UVXY, TVIX) has tripled since February 11 and recently stood at ~290 million, a record high."

In short, someone has been aggressively preparing for the next vol spike episode, even as VIX itself has barely budged while the VXX recently hit fresh split-adjusted record lows.

All of this brings us to the point of this article, which focuses on the most recent observations by JPM's quant guru Marko Kolanovic, who moments ago released his latest report. Not surprisingly for a man who deals with "Greeks" all day long, the topic of his note is precisely this curious decoupling between vol flows and realized vol. More importantly, it is volatility that is flashing a red light for Kolanovic, who says that "given the low levels of volatility and high levels of leverage, the main risk for the market remains a potential volatility shock."

Risk for the market, yes; but not for those who have been aggressively allocating funds into vol-related products - if indeed a "vol shock" does take place and send the VIX soaring into the 30+ range as it did on August 24, 2015, there will be a few more traders who will be able to retire early.

Here is his full take on what he sees as the "main risk for the market"

Over the past 2 months, low volatility and positive equity performance attracted Equity inflows into various systematic strategies. Our estimate for the total equity exposure of Volatility Targeting, Risk Parity and CTA funds is shown in Figure 3 below (blue line; note the correlation with net speculative S&P 500 E-mini futures positions – red line). Overall, the equity exposure of various funds is high, but not peaked in April but declined somewhat over the past 1-2 weeks. The exposure of CTA funds is substantially below its 2015 peak (they largely closed shorts but did not build large long positions). Most of the levering appears to be on account of Volatility Targeting strategies that invest inversely proportional to market volatility.

Clients have asked us why CTAs never reached their 2015 highs of equity exposure as momentum briefly turned positive in April (or why they didn’t go fully short as momentum briefly turned negative over the past week). Given that the market is roughly flat on a 12, 6 and 1 month basis, the momentum signal has been volatile, i.e. small S&P 500 moves can make it shift between positive and negative. This signal instability increased Equity tail risk for trend following strategies, and likely caused them to reduce overall equity risk allocations. We also believe that several trend following strategies may have resorted to buying Equity call options, to mitigate risk related to market turning points (i.e. ‘short gamma’ risk). In terms of CTA signals and flows, the main near term risks include Oil signals turning solidly positive this week (leading to further inflows as 6M price momentum turns positive), and equity short term momentum turning negative next week (leading to potential outflows as 1M price momentum turns negative). The Equity exposure of hedge funds (e.g. HFRXGL) has also come down over the past 3 weeks (from ~75th historical percentile to about average levels of equity exposure)

Given the low levels of volatility and high levels of leverage, the main risk for the market remains a potential volatility shock. Over the past month, low volatility resulted in significantly higher market liquidity. Figure 4 shows the market depth of S&P 500 futures over the past 6 months. One can see that market depth now is almost 3 times higher than during the lows of August or January. This is one of the reasons why the reduction of equity positions of hedge funds and risk parity funds over the past few weeks did not cause much market volatility (i.e. the market easily absorbed it). However, if volatility were to increase, liquidity would dry out quickly. The inset to Figure 4 below shows the relationship between market depth and the VIX. For instance, should the VIX increase above ~20, market liquidity (depth) would like get cut roughly in half. It is this relationship between market volatility and liquidity that leads to increases in ‘volatility of volatility’ (i.e. alternating periods of extremely low and extremely high volatility).

Kolanovic, is of course right, that another spike in "volatility of volatility" could quickly deflate all the market euphoria built up over the past 4 months. The only question is the timing of said event. While we don't pretend to know when said inflection point will come, all those who are aggressively rushing to purchase either direct vol exposure via VXX shares (see top chart) or various other vol-related gamma exposure, are certainly confident to put their money that this moment is imminent.