History Tells Market Sell-Off Is Not Over Yet, Extreme Event Trades in Focus

The global stock market experienced a sudden Black Monday, with the S&P 500 and Nasdaq down 3%, the Nikkei 225 plummeting 12% (the largest drop in its history), and the Korean index falling 9%. While many of these markets are bouncing back from Monday's crash, with both S&P 500 and Nasdaq 100 futures up almost 2%, history suggests that the rebound may be short-lived, and many believe a further crash is on the way.

On Monday, the Cambria Tail Risk ETF (symbol: TAIL), which manages tail risk in the U.S. stock market, surged 4.5%, marking its best single-day performance since March 16, 2020. At that time, amid early pandemic panic and a liquidity crisis, the S&P 500 plunged 12% in a single day, coincidentally also a Monday.

Post-decline rebounds are often the norm, but history shows they are usually short-lived. After a sharp drop in the S&P 500, the index rose 6% on March 17, fell another 5% on the third day, hovered for a day, and then dropped over 4% again on Friday, finally hitting bottom the following Monday. Although the current situation is different from the past, it serves as a good reference.

The short-lived rebound is due to investors believing that a sharp decline is the best opportunity to buy the dip. Rather than missing out, they act immediately, driven by FOMO (Fear of Missing Out); some aim to profit from the rebound, while others seek to lower costs for long-term investments, which is effective in a steady bull market. However, large institutions with a short-term pessimistic outlook take this opportunity to cash out, causing retail investors, who just entered the market feeling complacent, to suffer again when the market turns and starts selling off, leading to further index declines. When the market becomes thoroughly pessimistic, big players can re-enter.

Some pessimistic investors have already started preparing for extreme events. In the options market, the cost of hedging against a 30% drop in the S&P 500 index has reached its highest level since March 2020.

We can see across a variety of volatility metrics that there is heavy demand for 'crash' protection, the likes of which we haven't seen since the peak of the COVID shock, said Charlie McElligott, a cross-asset macro strategist at Nomura Securities International Inc.

Meanwhile, the VVIX (which measures the volatility of the VIX) also climbed to its highest level since early 2020 on Monday. The higher the VVIX, the greater the future market volatility expected by participants, and the uncertainty increases.

Tail risk hedging is only effective during sharp sell-offs, that is, major drops, but it is less significant during gradual declines. These funds are designed to continue losing until a market disaster occurs, bringing huge returns.

Tail hedges are coming into play, so good for those who had them on already, said Chris Murphy, co-head of derivatives strategy at Susquehanna International Group. However, for those looking to add tail hedges now, they have gotten very expensive very quickly.