Rapid shocks. The Covid example

Instead of prolonged crises, capital markets suffer highly destructive hits in very short periods of time. This is not a statistical oddity or the quants’ fault. These events tend to be idiosyncratic and strongly procyclical, amplifying calm and triggering sudden sell-offs.

The S&P 500’s volatility shows better averages but very volatile margins at its levels. A good example is Covid. The calm that preceded it is striking. Although the VIX warned us of the recession risk the pandemic could bring, when fear unfolded the declines were truly dramatic.

The possible causes we have already mentioned. One first cause may be options: as bond yields fell since the financial crisis, everyone sought ways to boost returns. The common tactic is options, which allow us to give up (sell) upside potential (call) or protect against declines (put), both in exchange for premiums paid to the derivative buyer. Option strategies were executed by hedge funds, but retail investors are now frequent users of these mechanisms. Also, it is the banks, on their balance sheets, who stand on the other side of the contract. That means banks must offset this risk themselves, which also leads them to seek hedges.

Professional funds aim for neutral positions, so they frequently hedge their option exposures. As we saw, this provides greater stability in calm markets but greater volatility in selling markets. During Covid, puts rose in value far too quickly. In many cases this led to a plan B: selling futures on the fund’s target equities to protect against the drop. Options are like an elastic band — they give flexibility until they snap.

A second cause could be VaR, which we have already mentioned; it uses volatility as a risk measure and, although simplified, allows buying risk (equities) in calm times but selling in volatility. We see a bias in modeling risk as if it could be fully eliminated. But to eliminate risk completely would require doing nothing. Often models are simplifications that, in practice, reveal their limits.

A third cause could be volatility targeting, which we have also explained. We may have a fund required to target 20% volatility in a market where only 10% volatility exists, so the fund must lever up to meet its objective (doubling its volatility). The problem arises when volatility increases beyond the fund’s contractual target, forcing rapid selling.

A fourth possible cause is liquidity. Today, high‑frequency trading firms dominate market‑making and therefore liquidity. Compared with banks that have reduced this activity due to regulation, trading firms generally do the job better, faster, and cheaper. Still, the balance sheets of these firms force them to be more cautious, because they have far less capital than bank trading desks had before the crisis. The deeper the market — the greater the number of buy and sell orders at each price — the more resilient it is said to be.

When we receive a shock, it triggers many sales, and most liquidity is provided by these firms, but they tend to retreat when markets are volatile, widening their quotes (bid‑ask spreads) to compensate for the additional risk, which generates many disproportionate moves.

Finally, in the case of Covid it may simply have been a negative shock to economic growth caused by the coronavirus collapse.

At some point, selling insurance against sharp moves was profitable and easy, helping portfolios boost returns. A good example were Autocallables (Auto Call). They generated additional yields during the era of ultra‑low bond yields and poor performance by many hedge funds and other active investors. But then there is the bet on volatility, the other side of the market. Volatility carry essentially consists of systematically collecting an insurance premium from investors willing to pay for protection via derivatives.

Markets have decided to bet on stability as if it were a sure thing. After months of volatility and policy adjustments, investors and managers seem to have agreed on a narrative: the normalization of monetary policy and the moderation of inflation will allow risk assets to regain ground without shocks. That confidence, however, comes at a price: it rests on fragile assumptions and on the hope that no unexpected shocks will undo in hours what has been built over weeks.

In practice, that bet translates into flows toward assets that benefit from an environment of steady growth and interest rates that, although higher than a few years ago, are no longer expected to surge. Central banks, for their part, remain central players: any sign of further tightening or persistent inflation could force a rapid reassessment of prices and risks. Meanwhile, the hunt for yield pushes investors toward more complex and less liquid products, promising coupons and partial protections that, in extreme scenarios, may prove insufficient.

Systemic risk has not disappeared; it has shifted. What was once a concern about liquidity has become a bet on the resilience of bank balance sheets, the health of issuers, and the ability of credit markets to absorb stress. In that context, prudence is not an aesthetic choice: it is the difference between riding a wave and being swept away by the current.

If anything the current situation makes clear, it is that the expected stability is a collective construction: it depends on policy decisions, investor confidence, and the absence of geopolitical or macroeconomic surprises. Betting on it can work—and in fact it is working for many—but it is worth remembering that big bets are often paid for with volatility when the script changes.