Heisenberg Report

A Nightmare On Wall Street – Updating The Feedback Doom Loop (Again)

Listen, there is a non-negligible chance that you have unwittingly sowed the seeds of this market’s demise in your ill-advised attempt to make a side career out of being a vol. seller.

And relatedly, if you’re someone who is long levered long VIX products, you too are in on this accidental plot to destroy the market.

See, lots of people have been trying to warn you about what it is these VIX ETPs are doing in terms of creating the potential for a nightmarish feedback loop, but not a whole lot of market participants seem to be listening.

If you need a refresher from someone other than Deutsche Bank’s Rocky Fishman and/or JPM’s Marko Kolanovic, let BofAML tell you what it is you’re accidentally doing:

In their quest for yield, market participants have increasingly turned to inverse volatility products to generate positive carry. Current positioning in these products is near all- time extremes at -$110mn vega (Chart 10). A volatility spike may pressure investors in these products to trim their positions, thus exacerbating the rise in vol.

Apart from this, the gross vega outstanding in inverse and levered VIX ETPs stands near $200mn vega, not far from the all-time high of $250mn vega registered in Apr-16. Mechanically, when vol increases, inverse vol products become overexposed to volatility and thus need to buy vol to reset their exposure. Similarly, when vol spikes, leveraged long products become underexposed to vol and also need to buy vol to reset their leverage. Thus, in a fragility event, this implicit “short VIX gamma position” can further exacerbate a vol spike.

That’s the “feedback doom loop” and it’s the basis for we’ve variously described as “a nightmare on Wall Street.”

We like to update you on this occasionally with the latest figures because the problem is that if the scenario outlined there by BofAML plays out, the supercharged vol. spike could cause a domino effect for systematic strats that would force them to deleverage into a falling market. You can read the last update here.

Below, find the latest reading on the all-important vega to buy on a [N]-vol VIX futs spike figure, via Deutsche Bank:

And as for that -$110mn vega outstanding figure for inverse products cited by BofAML above, well, it hasn’t budged since that commentary was released more than a month ago:

So you know, if your positions are reflected in those numbers, then just know you’ll be able to look in the mirror when you’re looking for who to blame if/when something finally tips the first domino and sets off the chain reaction.

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