• Stocks are vulnerable to a 5% “air-pocket drawdown” as traders short volatility, Sevens Report Research said.

• VIX futures contract expirations recently began having a much greater impact on the S&P 500, reminiscent of 2018’s “Volmageddon” episode.

• “These expirations will remain dates to take into accout because the specter of volatility will likely be elevated as we move further into 2024,” a note said.

Tuesday’s stock-market pullback after a hot inflation report actually showed us something else in regards to the market, one research firm says — and it may lead on to a sell-off later this yr.

“Stocks on Tuesday appeared to have an additional influence weighing on the broader market,” Tom Essaye, the founder and president of Sevens Report Research, wrote in a note on Thursday. “Evidently it did… an overcrowded short side of the alternatives market which was reminiscent of the 2018 ‘Volmageddon’ event.”

The “Volmageddon” episode happened six years ago after traders piled right right into a bunch of ETFs that were designed to return the inverse of market volatility (essentially betting on a peaceful market). And when volatility went up in February 2018, it tanked those strategies, sending the S&P 500 down greater than 10% in two weeks.

Investors appear to be taking dangerous bets again, specifically in VIX futures, which might be assets that allow investors bet on future volatility. As VIX futures expire, the S&P 500 is seeing stronger price reactions.

“Based on the magnitude of the move in VIX futures on Tuesday, there’s an increasing threat that the rising level of greed inside the ‘short-volatility’ trade, very like what we saw in 2018, could end in an air-pocket drawdown of 5% or more inside the S&P 500,” Essaye said.

The short-volatility trade became very popular after 2010 when volatility was low, and traders could generate income betting against market turbulence.

The Cboe Volatility Index, which may also be dubbed since the VIX or the market’s “fear gauge,” is sitting at 13.97, near historical lows.

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“The rebound in interest in short-volatility strategies is over again posing a risk to the broader markets here as a negative catalyst can clearly spark a momentous, derivatives-driven selloff inside the broader stock market like that which we saw in 2018,” Essaye said.

It isn’t a major concern immediately as volatility upticks have been small, and the S&P 500 has remained resilient. The market shrugged off Tuesday’s pullback quite fast. Nonetheless it’s price maintaining a tally of since the yr progresses.

“Going forward, these expirations will remain dates to take into accout because the specter of volatility will likely be elevated as we move further into 2024,” Essaye said.

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