Well then, with the VIX now back at a 15-handle, and with the NDX VIX surging as the Nasdaq breaks below its 50-DMA, this is probably a great time to update you on exactly what happens in the event we get a sustained vol. spike.
The first, and perhaps most important number of all, is the infamous vega to buy on an “N-vol” move in weighted average VIX futs. Colloquially, this is the “oh-shit-o-meter” – or, a way of estimating the magnitude of an expected mad rebalancing scramble by inverse and levered VIX ETPs.
Here’s an updated chart on that (current through today) from Deutsche Bank :
Now have a look at the rising interest in puts on SVXY:
As DB dryly notes, “a spike in vol, exacerbated by positioning in the VIX ETP complex with ~100m vega to buy on a 5-point move in the weighted average VIX future, could easily lead to these puts being ITM quickly.”
Yes, “easily” and “quickly” or, in other words, the bottom could fall out in a heartbeat for these short vol. products and indeed SVXY is down 11% midday.
You can think about that two ways:
- You could call it cruelly ironic: after all, it is the popularity of these products that has served to embed the feedback loop that will ultimately be the cause of their demise. They will almost invariably become victims of their own “success.”
- You could also just call it poetic justice.
Here’s a quick snapshot of vega outstanding by product:
With all of that in mind, we present the following from a Barclays note aptly entitled “What Would Happen If VIX Spikes?”
- The low level of VIX has raised concerns that a fundamentally driven move in VIX might be exacerbated due to positioning in VIX products. As the equity market continues to make new highs amid historically low realized and implied volatilities, investors have begun to fear that the market has become too complacent. The worry is that an unexpected shock could lead to sudden down move in equities and an attendant spike in VIX and VIX futures. In this report we focus on the impact from the leveraged VIX ETPs (which include the inverse VIX ETPs such as XIV and SVXY and the 2x leveraged ETPs such as TVIX and UVXY). We show that while a rude awakening from the prevailing complacency could indeed lead to significant increase in VIX, some of the positioning-related concerns are misplaced.
- We estimate that in a shock scenario 1M VIX futures could spike by 50% in a day. Using data from 1926 we show that large one-day SPX drops are rare after a period of complacency (low realized volatility) and a -5% move is an adequate shock scenario. We estimate that this translates into a move of 14 points for the VIX and ~6 points for the VIX 1M future or -50% return for the SPVXSP index (which is the benchmark for VIX ETPs).
- However, in such a scenario, volume in VIX futures could easily cross $1Bn vega. Liquidity in VIX futures has increased substantially in terms of both base of the volume and its tendency to spike during risk-off events. We predict VIX futures volume will likely cross a million contracts ($1Bn vega) in a shock scenario.
- Flow from managers of Leveraged VIX Exchange Traded Products (LETP flow) saturates for large VIX moves. We show that the VIX futures demand due to LETP negative gamma does not increase linearly but eventually saturates for large positive moves. In our shock scenario we estimate a demand of ~$110Mn vega which is only 10% of the likely VIX futures volume.
- On the other hand, for a large drop in VIX futures, the supply is not bounded and is thus a bigger concern.
- Flow due to forced unwind of inverse VIX ETPs if VIX futures increase by ~100% is not an incremental effect. The impact of the managers of XIV exercising their option to close the fund or potential margin call for SVXY in this scenario is already reflected in the LETP flow calculation and is not an additional effect. We demonstrate that negative LETP gamma is precisely the managers meeting margin calls by reducing positions.
- Short interest in inverse VIX ETPs has increased sharply which will likely mitigate the impact of LETP flow. A potential reason is that this roundabout way of going long volatility is more cost effective due to the positive carry from the negative LETP gamma. However, this strategy, whose payoff resembles a covered call in VIX futures, underperforms for extreme moves in VIX futures.
- In our opinion, the counterparties of the short-sellers of inverse ETPs are market-makers whose long gamma is mitigating the impact of LETP manager flow. One piece of evidence is that the LETP flow as measured by the intra-day autocorrelation of VIX futures has declined substantially over the past few years.
Got all that?
That effort should be applauded, but needless to say, there are a laughable number of assumptions built into those estimates.
The bottom line is that when answering the question Barclays sets out to address…
… the only honest reply is: “nobody fucking knows for sure.”