No one in the money management business should have been surprised by what happened on Monday.
The idea that “nobody saw this coming” is an excuse people are using to try and deflect from the fact that they didn’t take the time to engage enough with the research being conducted on levered and short VIX ETPs to understand what the rebalance risk would entail in a worst case scenario. Simply put, they did not take this chart – this is just one iteration from a January 10 Goldman note – seriously:
That chart is not hard to understand for professional investors. Just a 3-point spike in VIX futures (so, from the then weighted average of 11.5 to 14.5) would have forced VIX ETP issuers to buy $110mm vega. That, Goldman’s Rocky Fishman said at the time with some alarm, was “double the highest ever seen before 2017” and represented “~60% of daily 1st/2nd VIX futures volume, and around 30% of open interest.”
We detailed that on January 11 in a post called “‘The Biggest Risk Is A Quick SPX Selloff At The End Of The Day’: It’s Time For A ‘Doom Loop’ Update” and we have been talking about it for more than a year in our “doom loop” section (and yes, that’s right, we have an entire section of Heisenberg Report dedicated to the dynamic behind what happened on Monday and that section has been up, right here, on this site, available to anyone who cared to read it, for more than a year).
As for retail investors, it’s tempting to say “well, they got what they deserved because all they had to do was read the prospectus,” but that’s not entirely fair. It is not always reasonable to expect retail investors to conduct adequate due diligence. That’s just not how the world works and in this case, simply reading the prospectus wouldn’t have been enough. You can’t hold someone accountable if it isn’t reasonable that they could have known any better, so the solution is benign paternalism – that is, you don’t let the morons make the trade in the first place. This week, Fidelity banned retail investors from the trade.
But again, professional investors and pundits who used to be professional investors who are now pretending like “nobody saw this coming” are lying. Plain and simple. There are all kinds of people who saw this coming. And not in that Michael Burry, “Big Short” kind of way. This was obvious. The banks had been writing about it for the better part of a year and they were all (every damn one of them) out with postmortems this week (see here, here and here).
“As noted in our 2018 Outlook, while we did not see short volatility positioning as large enough or levered enough to catalyze the next global crisis, we were concerned about the risk of an outsized VIX spike in 2018 with little forewarning, potentially amplified by a short vol positioning squeeze,” BofAML wrote in their own piece documenting the carnage. Note how they start out by saying “as noted in our 2018 Outlook.” In other words: “we tried to tell you this was going to happen, but did you listen? Noooo. You didn’t listen.” BofAML continues as follows:
February 5th delivered exactly such a VIX spike, with the constant maturity VIX 1-month future recording its largest spike in history (by a wide margin) relative to the decline in US equities (Chart 11). Indeed, the 94.4% rise in the constant maturity VIX 1M future was nearly 17.5x as large as the -5.4% drop in e-mini futures, easily the largest stress beta recorded (data since Sep-07) and a large enough percentage rise to leave some popular short volatility strategies at risk of losing 100% of their capital.
Particularly striking was the acceleration in the vol spike between 4pm and 4:15pm (Chart 12), when the front-month VIX futures contract rose nearly 10 vol points and the second-month contract rose nearly 8 vol points. For context, the largest close-to-close move ever recorded in the constant maturity VIX 1M future was ~5.5 vol points in Brexit. A likely driver of the parabolic vol spike into the close on 5-Feb was the sizeable rebalancing needs of levered and inverse VIX products, which by our estimates may have bought ~$250mn vega or a record 26% of the day’s volume ($930mn vega) traded in the front two VIX futures contracts.
There you go. Again. And we’re never going to get tired of reliving the moment when the rebalance risk was realized.
Ok, well guess what? Some folks not only knew this was going to happen, but also bet on it. Take this guy, for instance:
That’s Denver fund manager (and Andrew Ross Sorkin’s long lost twin) Justin Borus. Justin is 41 and he’s the the founder of Ibex Investors a 20-person outfit in Colorado that apparently manages something like $350 million.
Well, do you know what Justin did? No? Let me tell you what Justin did. Justin bought himself $200,000 worth of SVXY puts on January 2 for $0.34 each, that’s what Justin did.
According to Bloomberg, the fund had been doing this for “about a year” – so basically they were just rolling these lottery tickets, but see here’s the thing. They weren’t really “lottery tickets” where that means something that is so unlikely to happen as to be laughable. As noted above, and as detailed on countless occasions in the above-linked “doom loop” archive, what happened Monday was not at all far-fetched.
“People were laughing at us, saying this could never happen, this should never happen,” Borus told Bloomberg in an interview. “We saw people pricing this as a 1-in-5,000 event, but it was more like a one-in-five-year event.”
Two of the funds’ employees were out for a stroll in Denver on Monday when a client they were chatting with on the phone informed them that the market was falling apart.
“We came back to our screen and we’re watching the VIX and it’s moving with extreme velocity,” one of the pair told Bloomberg for the same interview mentioned above. “We’re laughing at every tick up until we realized what was going on. Cooper just looks at me and goes, ‘Oh man. The Vol-pocolypse just happened'”, he added. “Cooper” is the other guy.
And so, they sold those 6,300 puts they bought on January 2 for $200,000 for a cool $17.5 million on Tuesday, a gain of 8,600%.
Then they went skiing.
End of story.