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The Great Volatility Crush
Authored by Jared Dillian of The 10th Man,
Ten years ago, when I worked on the equity index derivatives desk at Lehman, we used to sit around and dream things up. Like, we wondered out loud if you could actually create a volatility ETF.
It seemed like a brilliant idea. Who wouldn’t want to buy volatility? There were some studies going around that said holding volatility as an asset class alongside a diversified portfolio could improve the portfolio’s risk characteristics.

Around the same time, the Chicago Board Options Exchange (CBOE), owner of the VIX Volatility Index, was busy thinking up ways to securitize the Index. So it listed futures on the VIX, allowing investors take a long (or short) position in a VIX future and be positively (or negatively) exposed to changes in volatility.
Not long afterward, the CBOE listed options on the VIX, providing leveraged ways to play increases or decreases in volatility. (If you think about it, an option on the VIX actually gives you exposure to the volatility of volatility.)
Rise and Decline of the VXX
I left Lehman in 2008, but my former boss went on to develop an exchange-traded note (ETN) that gave investors direct exposure to the VIX… the very idea we used to kick around during lunch. The ticker was VXX.
People were really excited about VXX. A volatility ETF—now that is a financial innovation. Naturally, everyone piled into it, especially after the financial crisis, which was the biggest bull market in volatility the world had ever seen. Everyone wanted to be long volatility.

As you can see, that hasn’t worked out too well. Why not?
One thing investors have learned the hard way is that volatility has a very high cost of carry. People discovered this a few years earlier with USO, the crude oil ETF. The crude oil ETF holds crude oil futures, but since futures expire, it has to roll from the first month to the second month. If the futures are in contango, there’s a cost to roll the position.
VXX holds VIX futures and has to do the same thing. The vast majority of the time, the VIX futures are in contango, and the term structure is very steep. It’s very expensive to hold VXX, just like it’s expensive to hold a plain vanilla option. It “decays” over time.
VXX does go up occasionally when volatility spikes, but then it goes back to being expensive to hold again.
A lot of people got burned on VXX. They thought it was rigged and blamed the issuer, but they just failed to understand the cost-of-carry concept.
A client once told me that he thought this was the biggest wealth transfer from retail investors to professional investors in history. And he’s probably right.
Well, it seems there are a lot of bored financial engineers out there, because a lot of other volatility ETFs have popped up in recent years. Like TVIX, which is 2x long volatility. Or XIV, which is short volatility. If volatility is expensive to hold, wouldn’t shorting volatility be much more fun?
As it turns out, it is.

A Mad Rush into Short Volatility
So people have been discovering this over time. And the short volatility ETFs have been accumulating more and more assets. Until the last two weeks—when interest in the short volatility ETFs exploded:

This chart is from my friends at Deutsche Bank equity derivatives. It may be a little hard to understand, but the point is that people have been fleeing long volatility ETFs and piling into short volatility ETFs, to the point where the public is no longer net long volatility, for the first time in history.
This may seem like very arcane derivatives stuff, but it is not. This has huge implications.
Many people think that the V-bottom that we got last week was about dip-buyers or performance-chasers. That is true, but the bigger story is that retail investors (and professionals, too) came in and crushed volatility in a major way by plowing money into short volatility ETFs.
Whatever happened to this whole bit about owning volatility (I often refer to it as just “vol”) to improve portfolio characteristics?
No more. Now we have the volatility equivalent of “buy the dip”…
Smashing the Vol Spike
There are a few implications here:
- There’s really no other phrase for this than “naked speculation.” And naked speculation doesn’t usually happen on the lows. It happens on the highs.
- Retail investors have forgotten that being short volatility means being exposed to unlimited losses, just like if you were naked short a call or a put. If we get a vol spike of the magnitude of 2008—or even 2010 or 2011—“investors” in XIV are going to be very unhappy.
- In my entire career, I’ve never seen the retail community interested in selling volatility as a strategy. If retail investors ever sold volatility, it was usually a byproduct of something unrelated. Retail investors want to short volatility because they think it works all the time—and they probably think that way because since 2011, it has worked all the time.
Another ancillary concern here is that the popular inverse and leveraged volatility ETFs have the same issues that plain vanilla leveraged ETFs do: they have to rebalance daily. As the leveraged vol ETFs get larger, their rebalancing impact becomes more magnified and could lead to instability.
The statement implicit in selling volatility is “I think things are getting back to normal.” But things have been normal for a long time. We’ve gone 1,000-plus days without a 10% correction, and we will likely go even longer, because that last correction wasn’t even 10%. I could probably think of five things off the top of my head that could get the VIX back to 40 or 50.
The equity derivatives market is in many ways so complex that the financial press doesn’t even report on it. They don’t understand much they report on as it is, but with equity volatility, they’re really in over their heads.
What I’m describing here is a sea change in investor attitudes that has profound implications for the rest of the market. What you do with that information is up to you.
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It's so easy, even a caveman can do it!
Gold, silver, e-minis, what's not to manipulate?
Good summary of a complex subject.
Some things should NEVER be securitized. Volatility is high on that list.
Yeah good article right until he said that "retail investors piled in and crushed volatility."
I rather doubt that.
In the Occam's razor world of the New Normal it ain't the retain investors who decided to 'crush volatility' creating a market V-bottom.
My favorite candidate(s) is some party interested inc reating the V-bottom with very deep pockets and an even deeper understadning of how you can wag the market dog with a volatility index tail.
TVIX....my worst position in 5 years....reverse split to nothing
Charts showing the $7,500 share price are fun, until one realizes how many reverse splits there were to get there.
1 for 4 Reverse splits on November 8, 2010, October 4, 2012, and November 8, 2013.
Good point.
3:30 PM has been the witching hour more than a few times of late;)
No participation + rigged market = no volatility
Just signed up for Short Volatility Wednesdays being offered by the PTA and Kiwanis Club.
Seemed like a no brainer. Everybody's doing it.
I don't understand it either and do not consider myself stupid. I just like simplicity. For me a buck is a buck, or it used to be decades ago before they figured that inflation is a key in lowering debt.
If I can't understand this, and many 'professionals' like that investor employed by Orange County who screwed up, forcing the place into bankruptcy. He didn't understand it either. Poker or black jack is a lot simpler. You bring cash to the table and be prepared to lose it all if you have a bad game.
Wall Street sells hope and dreams built out of methane gas produced by male cattle, and it is explosive as hell. Meanwhile the cons on the street will convince 'investors' the methane is a harmless by product, until the day when someody lights a match.
i traded VXX once, a few days before the Fed announced a QE episode. guess how that trade worked out?
they can keep suppressing vol with their monetary gimmicks and jawboning til the cows come home, the day it doesn't work, they are going to pay the price something fierce.
yep ... all his charts are post recession
the next recession is MUCH closer than the one in rear view mirror.
gonna catch a lot of people off guard
"I left Lehman in 2008"
haha
so did everyone else
Riiight!, my grip ball, Cramer bobble head, three sticks of Double Mint and a condom in a card board box all packed up by security and me escorted to the door.
This is NOT retail shorting the VIX, TVIX or VXX. Clearly this is the FED and their HFT hammering these to help the market continue the grind up. I think that this is going to lead to a major problem for them when the VIX really spikes back to 40 or 50. Time Bomb, tick tock.
Where do you pull the stats from to determine who is invested in VXX, etc... ?
I argued with an older guy once that trading is gambling. He still to this day believes trading is not gambling. Its the ultimate casino.It makes vegas look like a back yard dice game.
When you have money withdrawn from your check to your 401k, that is gambling. You just allow someone else to do it for you. Sure, you can move money around to different funds, but all you are really doing is telling someone else that you are tired of black jack and want to try craps. Also when the company gives you a match on your deposited money to your 401k, that is nothing more than a pit boss in Vegas giving you comps.
and if you diversify into several asset categories it's like playing, blackjack, keno, craps, and the slots all at the same time!
Driving a bus for a living is gambling- it's just a matter of what level you want to play the game.
soooo... ZH now features an ad right below the article which uses the same font and structure as the comments. I started reading one yesterday and felt really used, dirty, like I felt the first time I...well ya get the point...ZH cheesey is thy name. The ad policy is really getting out of hand and threatens the integrity of the site.
seriously, I used to think the site had some of that 'i' stuff.
Odd, but I don't see that. In any case, I noticed that Yahoo (where I have a little-used email account) began doing something very similar several months ago. I chalk it up to increasing (corporate) desperation (more clicks!), and perhaps ZH is simply outsourcing their marketing to jerks who subscribe to the same, "clever" approach.
well, you get what you paid for
but i agree with you ... in the past i've sent to tips@ZH very worthy (imo) info from FEDGOV warning on subprime, FHA, and such ... tyler(s) can't be bothered to post that relevant info ... instead, get the deluge of blogger posts, permabear cranks, ebola, etc.
The Tylers do have to keep the lights on, and all of us with adblocker aren't helping much.
From the earliest days, volk will pay up for a computer, and a sizable monthly fee for a connection, but when we get to the net, everything has to be FREE, even porn and stock quotes. I see your point, but what else is free?
The energy level needed to run this operation must be staggering. Sometimes, I think about starting my own damn blog, but I'm usually sober by morning;)
Speaking of sea change - where is the ZH coverage of the Catalan independence vote *TOMORROW*??? WTF?
trouble is you could corner the market in volatility and not affect the VIX at all. although i imagine if you had a position of size it would be because you were planning to either buy or sell in large blocks. well in theory if enough people bought GLD, (just keep hitting the bid) the etf would own all the gold in the world which assigns a lot of control, but if you own the VIX you just own a third party bet, and when you get your ass exposed like that someone is going to figure out a way to kick it.
This volatility may enter the markets through the currencies. The falling value of both the yen and euro will reek havoc through contagion. For months the major world currencies had traded in a narrow range as if held in limbo by some great force. This has allowed people to think we were on sound footing as central banks across the world continued to print and pump out money chasing the "ever elusive growth" that always appears to be just around the corner. Recently several major currencies made multi-year highs or lows depending on the match-up .
The Fed recently whacked the dollar down but for how long? Because of weak demand for goods and most of this freshly printed money flowing into intangible investments inflation has not been a major problem, but the seeds for its future growth have been planted everywhere. John Maynard Keynes said By a continuing process of inflation, government can confiscate, secretly and unobserved, an important part of the wealth of their citizens.
While there are not many Bond Vigilantes there are a slew of Currency Vigilantes and they are ready to make their presence known. Weakness in the value of the Yen, Pound, and Euro must not go unnoticed. More on why this may be a signal that currency trading is about to get very wild in the article below. Please note, this may also be sending a signal that the whole system is unstable and the stock market could drop like a stone due to contagion.
http://brucewilds.blogspot.com/2014/09/caution-alert-currencies-may-get-wild.html
"The Fed recently whacked the dollar down but for how long?"
Say what?
King Dollar has been kicking butt ... DXY 200 bps higher than when FOMC minutes came out a month ago ... warning of dollar strength
I you have a margin account, why not just short the 2X or 3X VIX over and over again for income rather than purchase an inverse? Shorting FAZ and TZA would have made you a ton too. Since everyone is against those instruments, you are correct >90% of the time in the short term and 100% of the time in the long term, given the decay.
I don't trade this stuff. In fact, I only trade option spreads, so consider the source.
I think, as the author points out, that would be right, on time value decay, but potentially very wrong if volatility spikes.
Same strategy as shorting puts on stock, overwhelmingly profitable most of the time, but high risk, (and high margin).
check that...too derivative a derivative, too many layers deep...to start it's trading a metric not an underlying and then trading options on that, what could possibly go wrong?
even if one guesses right - or gets lucky - on the vol the options premiums may/do get slammed (ironically appearing as dumped option vol).
"Listen, here's the thing. If you can't spot the sucker in your first half hour at the table, then you ARE the sucker."
Gosh, I've got to start my own ETF's. I've already got some great tickers picked out. Now I just need to sucker people into buying them... This is like buying domain names as I am searching right now and there are no funds registered yet with tickers: WTF, LOL, POS, etc... this is a gold mine opportunity.
Shorting volatility means you are betting that calm spots can be found in a stormy sea .
And they can , for a limited scope . See
https://www.academia.edu/9161529/P_NP_You_can_always_make_it_simpler_
Especially in what is a controlled economy . See
https://www.academia.edu/9160541/Laundry_Economics_
However , the uncertainty factor in https://www.academia.edu/9161529/P_NP_You_can_always_make_it_simpler_
leads to Black Swan events . Inherent and inevitable .
These can be steered , but not eliminated .
See
http://andreswhy.blogspot.com/2014/09/rogue-swan-weapons.html
http://andreswhy.blogspot.com/2014/09/rogue-swan-tech.html
Now if everyone jumps into shorts, then the money is to be made on the other side of the coin. Same as with the price of silver at the moment. Now throw into this mix the fact that the markets are being controlled by others. Which way do you think volatility and silver will me going on Monday.
If the markets remain constant no onw makes any monies
http://pragcap.com/quantitative-easing-the-greatest-monetary-non-event
QUANTITATIVE EASING: “THE GREATEST MONETARY NON-EVENT”2009
http://www.safehaven.com/article/35734/the-financial-repression-authority-with-john-butler
John Butler has 18 years experience in the global financial industry, having worked for European and US investment banks in London, New York and Germany. Prior to launching the Amphora Commodities Alpha Fund he was Managing Director and Head of the Index Strategies Group at Deutsche Bank in London, where he was responsible for the development and marketing of proprietary, systematic quantitative strategies for global interest rate markets. Prior to joining DB in 2007, John was Managing Director and Head of European Interest Rate Strategy at Lehman Brothers in London, where he and his team were voted #1 in the Institutional Investor research survey. In addition to other research, he publishes the Amphora Report newsletter which appears on several major financial websites. A cum laude graduate of Occidental College in California, John holds a Masters Degree in International Finance and Economics from the Fletcher School of Law and Diplomacy, associated with Harvard and Tufts Universities.
Financial Repression
BROAD DEFINITION: "Any Policy that constrains the ability of the financial markets and investor participants in these markets to take rational actions to invest, diversify and manage the risk of their investment as they would personally prefer to do."
NARROW DEFINITION: "A specific tool kit of policies implemented by government which indirectly confiscate the wealth of the private sector and move it to a combination of the public sector and/or "too large to fail" institutions."
FINANCIAL REPRESSION IS ABOUT LIMITING INVESTMENT CHOICE
"The whole point of financial repression is to make it difficult or impossible for an investor to protect themselves"
John feels Financial Repression "is now extremely broad based (globally) and in fact you have to look very closely to find countries not actively pursuing some mix of Financial Repression policies."
A Negative Sum Game
Butler has argued in his Amphora Report that competitive currency debasement is "is not a zero sum game but rather a negative sum game because policy makers don't realize that by trying to devalue against each other, unseen they are undermining the very credibility of unbacked fiat currencies generally."
Increasing the BRICS are "becoming increasingly wary of where all this is going and as a consequence are diversifying not only their fiat currency reserves but are diversifying into gold, oil fields and real assets generally."
How Investors Protect Themselves
"The only free lunch in economics is DIVERSIFICATION. The problem is that in a world of Financial Repression, the way you diversify yourself is very different than a world where financial represion is not an issue."
"There is no way out but Currency Debasement"
John outlines in this video specifically what the "new diversification" must consist of.
He believes the Fed "will blink" as the US dollar continues to rise as a consequence "of the deflationary pressures which are spreading across the world." He sees evidence of a major trend reversal coming in 2015 and possibly before the end of 2014.
https://www.youtube.com/watch?feature=player_embedded&v=brEfmCgWIIY
Vix, mix, dix! The start of an incantation of a doom dream?
so you're one of the ones responsible for blowing up Lehman? and you have the nerve to show your face here and come preaching? lmaof. Naked speculation? yah by hedgies and market makers and slimeball traders out of Deutschbank. Retail investors are still at all time low in the market and likely will stay that way for the next 30 years. lol naked speculation