Barrons
Dangerous Game: Shorting the VIX Funds’ use of leverage could add to a “super spike,” pushing down stocks and boosting volatility.
By STEVEN M. SEARS
July 29, 2017
As stocks keep dancing around record highs, and the CBOE Volatility Index remains historically low, some investors are preparing for a violent end to one of the world’s most popular trades: shorting volatility.
A one-day Standard & Poor’s 500 correction of 3% to 4% could force some funds that short futures on the index, such as the ProShares Short VIX Short-term Future s exchange-traded fund (ticker: SVXY) and the VelocityShares Daily Inverse VIX ST ETN (XIV), to cover their positions. That could make the VIX skyrocket.
If the weighted-average of 30-day VIX futures sharply jumped—say by 80% in one day—it would, in turn, trigger an “acceleration event” that would force more funds to buy back short VIX futures contracts. Some VIX funds could face margin calls. And a chain reaction would likely explode across the volatility spectrum and ultimately the stock market, pushing down share prices and boosting volatility further.
SO MANY INSTITUTIONAL INVESTORS use strategies that increase portfolio leverage as equity volatility declines that Marko Kolanovic, JPMorgan’s top quantitative strategist, fears the markets are nearing a turning point. “While these strategies include concepts like ‘risk control’, ‘crisis alpha’, etc. in various degrees they rely on selling into market weakness to cut losses. This creates a ‘stop-loss order’ that gets larger in size and closer to the current market price as volatility gets lower,” Kolanovic wrote last week.
The S&P 500’s realized volatility–the level that’s materialized already—is the lowest since 1966. That influences expectations for future, or implied, volatility.
In fact, CBOE Volatility Index levels are so meager that relatively small point moves can create big percentage changes, creating a major problem for VIX funds.
SHORT VOLATILITY STRATEGIES have become more popular since 2009, when the Federal Reserve and other central banks began supporting global markets after the financial crisis. Since then, stock market declines have been infrequent, and equity volatility has evaporated. Over the past year, selling one-month VIX futures yielded a 199% total return, versus 17% for the S&P 500, according to Goldman Sachs research.“The one-day percentage change is a big deal in the VIX complex because the levered and inverse VIX ETFs and ETNs rebalance daily, based on the percentage change, and some of the thresholds for forced [unwinding of positions] are based on the percentage change. This is why lower volatility creates higher risk,” Christopher Metli, a Morgan Stanley quantitative derivatives strategist, recently warned clients.
Joe Aiken, co-manager of hedge fund Malachite Capital, says that if something happened overnight that caused a sharp stock market decline, it could trigger a VIX “super spike,” with potentially dire effects.
“XIV would need to buy back all the VIX futures it is short, and the levered ETFs like TVIX and UVXY would need to buy to rebalance exposure as they do any day VIX futures increase,” he said. “Of course, this well-flagged buying pressure could create demand from other investors who may believe it is a good idea to buy when there’s known demand, which may create demand from still other investors who are anticipating that demand, and so on.”
Ralph Drybrough, co-founder of StratiFi, a portfolio-hedging service for investment advisors, is reducing his short volatility positions. At the same time, he’s buying relatively inexpensive VIX calls that would prove profitable if volatility surges. VIX calls with $20 strikes are popular for that reason. “Crowded trades work until they don’t work,” Drybrough warns, “and then capital simply disappears.
Here is an interesting news article from almost exactly 2 years ago.
Volatility Short-Circuits VIX
By Steve Sears Aug. 24, 2015 10:13 a.m. ET
Stock are so volatile that they've short-circuited the CBOE Volatility Index.
A CBOE spokesman said VIX, commonly known as the stock market's fear gauge, experienced quoting problems because of the whippiness of Standard & Poor's 500 Index prices.
The VIX is derived from the midpoint of various S&P 500 options, and the exchange claims those midpoints were tough to determine at the open.
VIX initially spiked above 50, and is now around 46.76. At these levels, VIX is pricing a global economic depression. |
