The S&P 500 is down 2 percent so far this week, sending volatility ETFs like the CR SUISSE AG NA/VELOCITY SHS SHORT (VIIX) soaring 20 percent. The huge spikes in volatility are bringing back memories of the wild trading in early 2018 that ultimately resulted in the collapse of a handful of inverse volatility funds.

Tom Essaye, founder of Sevens Report Research, addressed the volatility spike in a Wednesday newsletter and compared the current to what occurred last year.

A number of short volatility funds that take bearish positions on the VIX volatility fund increased their leverage heading into 2018 after the market’s steady rally in 2017. When trade war concerns generated a volatile market sell-off, these funds were forced to exit their positions, revealing a volatility-driven air pocket under the market.

Deja Vu?

Unfortunately, Essaye said current conditions suggest investors may be in for a repeat of what played out in 2018.

“As of last Friday, speculative net short positions in VIX futures and options just hit a new all-time high, so it looks like the ‘short vol’ funds are ‘all in’ again, like they were in Q1 ’18 and fall 2018,” he said. 

One red flag Essaye is watching is in the VIX futures market. Typically, VIX futures trade at a premium to the VIX index given that they are based on future month’s settlements. Yet in the case of the 2018 volatility spikes, the VIX futures and VIX index temporarily inverted.

“This week, the VIX reached levels considerably higher than every VIX futures contract that is on the board right now (through January of 2020) meaning the near-term demand for hedging via the VIX has surged in a market that is lopsidedly short." 

How To Play It

Looking ahead, Essaye said traders should be prepared for stocks to potentially overshoot to the downside in the near-term on negative trade war news. That extreme dip may be driven in large part to temporary market dynamics rather than underlying economic fundamentals and could serve as a potential buying opportunity, he said.