The High Risk Of Low Vol: Complacency, Moral Hazard, & Anxiety Attacks

Right, so low vol. is a hot topic these days.

Maybe you noticed.

In fact, persistently (and artificially) suppressed vol. found its way into a prominent story in the Journal this week called “The Snowballing Power Of The VIX.”

The subheading reads as follows:

Created to track expectations of volatility, it has spawned a giant trading ecosystem that could magnify losses when turbulence hits.

That “giant trading ecosystem” is comprised of over 40 VIX ETPs with an aggregate AUM of just under $4 billion. As Goldman wrote last month, they generate “an average daily trading volume of $2.6 billion [and] accounted for about 118 million vega per day over the first quarter of 2017 or about 22% of the total open interest in the VIX futures market.”

In the article linked above, the Journal cites Deutsche Bank’s Rocky Fishman, with whom regular readers are (very) familiar. For those who missed it, here’s his latest: “Feed Your “VIX-ation” – Rocky’s Back To Answer All Your VIX Questions.”

Essentially, the worry is that inverse and levered VIX ETPs will need to buy VIX futs into a spike in vol., potentially exacerbating said spike. This dynamic is itself exacerbated by the low level of vol., which creates a scenario where a nominally small spike is huge in percentage terms. Here’s how Rocky explains it:

VIX ETPs are a larger-than-usual feedback loop in markets. Inverse and levered VIX ETPs’ need to buy VIX futures when vol is rising and sell it when vol is falling creates a feedback loop in vol that can lead to high vol-of-vol. Currently, the combination of low VIX futures levels (making an N-point vol spike look like a huge percentage), large short ETPs, and large levered ETPs leaves over $70mm vega to buy on a hypothetical 5-vol spike in the VIX futures curve

However, it is uncertain how liquid the VIX futures market would be after that kind of vol spike. The large amount of vega to buy may be hard for the market to absorb in some stress events, which may cause further exacerbation of a vol spike.

And here’s JPMorgan’s Marko Kolanovic (aka “Gandalf”) saying exactly the same thing:

Given the low starting point of the VIX, these strategies are at risk of catastrophic losses. For some strategies, this would happen if the VIX increases from ~10 to only ~20 (not far from the historical average level for VIX). While historically such an increase never happened, we think that this time may be different and sudden increases of that magnitude are possible. One scenario would be of e.g. VIX increasing from ~10 to ~15, followed by a collapse in liquidity given the market’s knowledge that certain structures need to cover short positions.

But Rocky isn’t the only guy at Deutsche Bank that’s got something to say about this, and as good as he is at describing the technicals, nobody’s going to top his colleague Aleksandar Kocic when it comes to style.

Last weekend, we brought you Kocic’s take on this hottest of hot topics in which he explains the selling of vol. as the disposal of “waiting time.” If you missed that piece, you really should read it (“‘Waiting Time’ Sucks: What Is A Vol Seller, Really?“).

Well on Thursday evening, we got Kocic’s latest, and it’s short, but characteristically brilliant. We present it below without further comment.

Via Deutsche Bank

High risk of low volatility: Forward vol as a hedge

Complacency has moral hazard inscribed into it. It encourages bad behavior and penalizing dissent – there is a negative carry for not joining the crowd, which further reinforces bad behavior. Persistence of low volatility causes misallocation of capital. This is the main danger. For a given level of uncertainty, on the risk/reward curve investors settle at a point that corresponds to their risk limits. This position is determined by the cone on the risk frontier frontier, its width commensurate with volatility. As volatility declines, the cone shrinks and returns decline. This compels investors to move across the frontier towards higher risk in order to enjoy the same return.

This is the source of the positive feedback that triggers occasional anxiety attacks, which, although episodic, have the potential to create liquidity problems. Endemic complacency, which continues to take hold of the markets, is likely to play an increasingly adverse role the longer markets continue to operate as they recently have.

Although volatility remains depressed, the risk is being pushed to the tails. And, as volatility could continues to decline, a buildup of tail risk is likely to become more acute, as probability of volatile unwind increases.

The prudent way of hedging that exposure is by finding a carry friendly tail risk hedges. In our view, forward volatility fits exactly that description.

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