Hell, I don’t know if you’ve been paying attention to our market posts this week or not, and if you haven’t I don’t blame you.
After all, it’s hard to make yourself wade into finance commentary when it’s so much easier to click on the Trump coverage and rubber neck it as you drive by the smoldering wreckage of this administration.
But on the off chance you’ve been reading the VIX ETP stuff, you might recall that we’ve mentioned the big inflows into short VIX products and the big outflows from long vol. products on at least two occasions (maybe more, I can’t remember). Here are a couple of posts:
- The VIX, Trump’s Pulp Fiction Moment, And The Triumph Of BTFD
- The ‘Doom Loop’: How VIX ETPs Exacerbated Last Week’s Vol. Spike
In that latter post, we noted that based on the flows into SVXY and the flows out of UVXY, investors (if that’s what you wanna call them) were betting heavily on a quick return to the low vol. regime.
You can see that clearly in the flows through Monday:
Implicitly, that suggests that the ETP vega-to-buy (which sat at ~$100 million headed into the vol. spike) would have moved sharply lower on a rebalance and then spiked again on inflows.
Sure enough, Deutsche Bank confirmed that on Thursday:
VIX ETPs likely exacerbated the move in vol both ways over the last week. VIX ETP providers bought almost $90 million of vega following the ~1.5% down move in the SPX last week and the concurrent 3 vol move in the weighted average VIX future, likely pushing vol levels even higher on Thursday and Friday.
After ETP providers rebalanced, vega to buy on a further 5-vol spike fell sharply last Thursday, before rebounding quickly early this week. We also observed providers selling close to ~30m vega on Monday, possibly exacerbating the move lower.
On Monday we saw a decrease in the 2x long ETPs shares due to redemptions following the increase in vol. However, there have been very large inflows into the short VIX ETPs (mostly in SVXY), following last week’s selloff. These inflows and the quick retrace of implied vol levels mean that vega to buy on a spike has already jumped back to levels from just before the vol spike last week.
The combination of low VIX futures levels, large short ETPs, and large levered ETPs leaves ~$100mm vega to buy on a hypothetical 5-vol spike in the VIX futures curve.
Right. So there’s that. And because we can’t emphasize this enough, what that quite clearly shows is that there’s a kind of incestuous dynamic going on here. Here’s how we put it earlier:
The takeaway (and this is a point I’ve tried to make to quite a few people who are day trading these things) is that far from “riding the wave” or “playing the BTFD dynamic”, the people trading these ETPs are actually creating the wave/dynamic.
Note that last graphic above. That’s Deutsche Bank’s “doom loop” dashboard. It essentially monitors the likelihood and the potential magnitude of a situation in which inverse and levered VIX ETP rebalancing on a vol. spike (so basically, panic-buying VIX futs) causes vol. control funds and CTAs to delever into a falling market. If you need a refresher on the nightmare loop, you can start here and work your way back.
One thing worth noting on that “doom loop” dashboard: it’s pretty rare that everything in the “risk impact” column is shaded red.
Ok, so I probably don’t need to tell you this, but some of the sellside research on the short vol. trade has reached epic levels of absurdity in terms of trying to quantify the risk. It’s actually morphed into something of nuclear arms race between the big banks to see who can write the most complex note. At this point, I’d have to say Barclays is in the lead after publishing a veritable manifesto called “What Happens If The VIX Spikes?”
You can read excerpts from that War-&-Peace-ish piece here, but just trust me when I tell you that the actual, full note is so in-depth that it approximates something you might expect to find in a peer-reviewed academic journal.
One person who has a pretty good knack for writing about this in terms that human beings can digest is Peter Tchir. You can find his latest below and do note that while it’s a decent summary, he starts off on the wrong foot by pushing a bit of demonstrably “fake news.” To wit:
…people think that even Chuck Norris can’t make money buying vol.
No Peter, no one thinks that.
Because everyone knows that Chuck Norris can do anything Chuck Norris wants to do.
And in fact, Tchir seems to miss the only point that matters when it comes to Chuck Norris and buying vol.: Chuck Norris doesn’t need to wait around on volatility, precisely because Chuck Norris is the volatility…
Via Brean Capital’s Peter Tchir
You know a trade is getting crowded when my parents start asking about it. You know just how one sided something is when people think that even Chuck Norris can’t make money buying vol.
Last Week’s Spike in VIX has brought out nothing but sellers of volatility. I think selling VIX is very crowded and fraught with danger.
SVXY Shares Outstanding
SVXY a short VIX ETF is up to $1.3 billion in market cap. (it looks like it held about 30% of the open interest in the VIX September futures contract).
XIV Shares Outstanding
XIV, a short VIX ETN, has also seen inflows (though seems to be losing market share to SVXY) bringing its market cap to just under $1 billion.
So we have extremely large inflows into the vol selling ETPs.
UVXY Shares Outstanding
UVXY a double long VIX ETF is down to $275 million in market cap. Shares outstanding dropped nearly 50% as profit taking (or smaller loss seeking) pulled money from the strategy.
VXX Shares Outstanding
VXX, an ETN, is still just above $1 billion in market cap.
So we have large outflows in the long VIX ETPs.
I think that the strategy of selling short term VIX futures is not only extremely popular, but that the recent spike in VIX encouraged a large number of investors that it was time to reload on the trade or enter into it for the first time – very crowded.
Relying on ‘Bend Don’t Break” Is Dangerous
As far as I can tell, investors have adopted a “bend don’t break” view on VIX. That is can go higher, but it will always ‘revert’ to the mean. So longer term, you get back the losses and the steep vix futures roll kicks in.
VXX Shares Outstanding
VXX is up 800% since it was launched in late 2010. SVXY, which was launched later is similar.
VIX Short Term Futures Index
The index that most of these funds track is down 99.8% or something since it peaked. It is down virtually every year.
I believe that investors have now decided that selling VIX is the ultimate buy and hold strategy.
Can VIX Break?
Either this strategy “can’t lose” over time, or there is something wrong with the logic.
Let’s start breaking down the logic
The VIX Curve Is Not Particularly Steep Right Now
The difference between the second VIX futures contract (UX2) and the first VIX futures contract (UX1) is only 0.45. That is well below the average historical difference – that means that the ‘roll effect’ is greatly diminished. Sellers of vol will need to wait longer to recover from losses, then if the curve is steep – but that still fits into the ‘bend don’t break’ meme, rather than breaking VIX.
I want to highlight how inverted VIX becomes at times of stress.
Every period of stress has involved a serious inversion. The financial crisis saw the most extreme rise in VIX (as per the futures index value) but also had extreme inversion.
This is where I think I need to highlight a few things
- The VIX futures contract just rolled this week, so the bulk of the exposure in the index is to the front contract (above 90% I think). I think from a practical standpoint, and VIX ‘break’ will occur while the index is heavily skewed towards the front end – precisely because it shows a tendency to invert at times of stress (so if and when trying to time VIX breaks I would target periods where the contract is mostly in the front end)
- SVXY was short 90,000 UX1 contracts. The equivalent hedge for XIV is about 70,000 contracts (we do not know how CS hedges the exposure). That would make those two indices with 160,000 UX1 shorts out of open interest of less than 300,000 contracts – well over 50% of the open interest in UX1 can be explained by these two ETPs.
- These ETPs did NOT exist in 2008 – so I don’t see how you can rely on historical data back then. In the past, VIX was merely an observable calculation (a complex one at that). Now VIX is a tradable product in its own right – with daily rebalancing that tends to push it in the same direction that it moved throughout the day – plus all of the other technical that can occur when a product is traded – rather than just calculated. I personally don’t trust the data even in 2011 since these ETPs were in their infancy back then – not the 800 pound gorillas they have become.
- XIV terminates if the underlying index is down 80% in a day. Poof. Gone. It will pay cash at whatever residual value is left after unwind. If CS was simply hedging with the 70,000 futures contracts, that would cause immense demand for futures on what could only be described as a very nasty day (80% hasn’t happened – but these products didn’t exist). SVXY is not explicit on what it does on a large move day – I suspect, that is part of the reasons inflows into SVXY are so much larger than XIV. But, SVXY has margin agreements in place, and since it isn’t a charity, I would think that it shutters its doors at some level below down 100% (they can’t ask shareholders for more money, so the margin counterparties would shut down the trades. If the trades don’t exist, I’m not sure how the ETF can). So imagine that XIV knocks out, which triggers a VIX spike, which knocks out SVXY. It seems incredibly unlikely, but then again AIG was ‘AAA’ and ‘super senior’ was super safe. Housing prices, on a national basis, had never declined. Lots of ‘impossible’ things seem to happen once financial engineering drives them too far. What is really perverse, because I can’t think of a better word to describe it, is that for everyone who would be looking to sell vol when it hits 25 or some high number wouldn’t be able to – because the two easiest ways – buying these ETPs wouldn’t be an option.
Yes, VIX can break. It is highly unlikely, but not impossible.
What To Do?
I would NOT be selling volatility here. My title was dripping with sarcasm.
I like buying VIX calls here – even something that seems as unlikely as a 20 strike. Pure ‘lottery’ ticket type of trades.
When I wrote this weekend that I thought VIX would hit 20 before 10, I was extremely nervous as VIX collapsed on Monday as North Korea backed down. My bad case, that I laid out in Sunday’s report – does, unfortunately, seem to be gaining traction – and I think selling VIX is very crowded and might disappoint those who entered the trade recently. There is plenty of room for some fund flows into the long VIX products like UVXY – which is the most dangerous in both directions as it rebalances daily – constantly adding flows to the directions it already moved.
Keep an Eye on Risk Parity/Vol Targeting Strategies
There might be nothing to it, but treasuries and stocks were both weak this morning. Once the Cohn headlines hit and were then retracted, stocks remained near the lows while treasuries quickly eased off on some of the gains (the long bond is lower on the day again).
Realized Vol Is Increasing in Risk Parity Strategies
This is one fund that I track and realized vol is nearing its highest for the year.
I think that most sophisticated Risk Parity strategies had plenty of cushion in terms of vol and correlation before needing to sell assets – but as we remain at what now passes as elevated vol – we should keep an eye out for any signs of flows from these strategies – where weakness in both long dated sovereign debt and equities is the biggest risk (some commodity weakness wouldn’t help matters).
I doubt we are seeing anything meaningful from Risk Parity but it is worth watching.