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How The Entire Short Volatility ETF Complex Could Be Wiped Out Overnight
Excerpted from Artemis Capital Management letter to investors,
Global central banking has artificially incentivized bets on mean reversion resulting in tremendous demand to short volatility. The growth of short volatility exchange traded products (“ETPs”) since 2012 is nothing short of extraordinary and at the end of August, total short volatility assets exceeded long for only the second time in history. The rise of this short complex is intrinsically linked to the recent schizophrenic behavior of the VIX and adds significant shadow convexity to markets.
Velocity Shares Daily Inverse VIX (“XIV”) is the largest of these short VIX ETPs and has a cult-like following among day traders. Although the product has gained +111% since 2012, when decomposed on a risk-adjusted basis, it basically resembles a 3x levered position in the S&P 500 index with more risk. As the short and leveraged volatility complex becomes more dominant it is contributing to dangerous self-reinforcing feedback loops with unknowable consequences.
Many retail investors simply do not understand that short and leveraged volatility ETPs rebalance non-linearly (see below). To the casual observer it may appear that short and long assets counterbalance one another but this is not the case. For example if the first two VIX futures move 20% higher the short volatility ETP providers must buy an estimated 33% more volatility (vs. 25% for long) to balance that exposure. The first rule of derivatives hedging is that you never hedge a non-linear risk with a linear tool. The mismatch means a large move in spot-volatility in either direction requires excessive buying or selling pressure whenever short volatility assets are dominant. Therein lies the problem. Falling volatility begets falling volatility and rising volatility begets rising volatility.
The great unknown is that this massive short volatility animal that appears tame given a regular diet of central bank liquidity may turn wild when that liquidity is removed. The wrong ‘risk-off’ event may expose a hidden liquidity gap in the short VIX complex that could unleash a monster. Artemis has attempted to quantify this theoretical liquidity gap by gauging the percentage of VIX open interest and volume required by exchange-traded products for rebalancing.
During recent market stress points such as October 2014 and August 2015 the short and leveraged volatility ETP complex required upward of 40-50% of the total liquidity of VIX futures as measured by average trading volume and open interest. Consider that the largest one day VIX move in history was the +64% jump that occurred on February 27, 2007 when the VIX went from 11.15 to 18.31. This was not even a period of high financial stress! If a similar volatility spike occurred today, given the current size of the short VIX complex, the ETPs by themselves would require an estimated 95% of the liquidity for rebalancing!
This would drive the price of the VIX futures up further exacerbating the nonlinearity. The VIX futures market may struggle to absorb the demand for long volatility. Dealers seeking to plug the liquidity gap would purchase S&P 500 options and forward variance swaps. The excess buying pressure exerted from the short-volatility complex would then push spot-VIX higher contributing to panic selling in the underlying S&P 500 index and a vicious and self-reinforcing cycle of fear followed by horror.
The recent bi-polar behavior in spot-VIX empirically supports the theory that a structural weakness now exists in this market by crowding of short volatility players. The shot across the bow for the short volatility complex came during the August 24th correction when SPX futures opened limit down and the CBOE struggled for 30 minutes to calculate the VIX. By the time the VIX level was finally calculated it opened 25 points higher at 53.29, before falling to 28 intra-day, then rebounding to 40.74 by the close, with the S&P 500 index down -3.9%.
At the time of the crash, the assets in long VIX ETPs outnumbered shorts on a two to one basis however, the complex still required an estimated 25% to 46% of market liquidity between August 21 and 24th. Markets delivered historic volatility-of-volatility despite relatively mild historical declines in the S&P 500 index. It is important to understand that markets have experienced much more dramatic oneday losses across history than what occurred in August 2015. For example on August 8th 2011, the market suffered a oneday decline of -6.7%. September to December 2008 experienced ten declines of more than -5%, and on Black Monday 1987, the market fell an incredible -20.5% in one day. During the Black Monday 1987 crash implied volatility in the S&P 100 index more than tripled going from 36.37 to 150.19.
If the VIX experienced any of these historic moves at current levels of short convexity the entire $2bn+ short volatility ETP complex would likely be wiped out overnight.
Short volatility sellers ridicule the fact that the prospectus for the iPath Long Volatility ST Index (VXX) clearly states that the ETF has an expected long-term return of zero. They should ask themselves, is it better to know with certainty you are going to go bankrupt slowly, or be completely ignorant of the fact you will go bankrupt suddenly.
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Eventually all bubbles pop. The Fed makes them nice and big.
Can't wait till this all goes down. Going to be fun. This is why I never hold a short vol overnight.
ETF's are designed for the sheep to be fleeced as they degrade faster than options.
Great way to make money for the issuers, day in and day out.
Get out of the casino
AIN'T GONNA HAPPEN WITH YELLEN AT THE HELM OF THE GOOD SHIP LOLLYPOP
happy landings on a chocolate bar bitchez
After the election. Depending on who wins.
Very good article, thanks.
Wonder if there's someone getting on the other side of this trade. Seems like a chain reaction that would just need a litle spark (eg. risk-off event) to get started. Interesting Goldman note on vol. I love horror movies. *Pops popcorn*
To be on the other side and benefit you need to be long "TVIX".
Have fun,
Good article.
Another good topic would be the other tools like turbo's, speeders and warrants and what is killing deutche bank right now.
There in europe, those turbo's and speeders are one of the most traded instruments in the last decade and my guess is that the sudden flash crashes and spikes have their origin here as 1 spike in any way, even for a microsecond, wipes out every position that crosses that stop loss.
Yep, been saying it for years. The next one is going to be fueled by ETFs/ETPs for this reason. The movements start to get exponential with these products and no one investing in them understands that
This is a very impressive article that will glaze the eyes of most people. I have a feeling that we are rapidly coming to the day where their analysis of the XIV and similar ETP's are going to be proven right. I watched over the last week and a half the systematic shorting of VXX with the intent of pushing the market higher, and it worked. Once the S&P hit the 100 day MA today as well as 2040 (previous support which is now resistance), the downward pressure on VXX suddenly disappeared, and the next thing you see is VXX up almost $1, even though the market was barely down. If anyone is long this market, I would advise lightening up on your risk exposure, because the market looks poised for a sharp, fast downward move.
Look at the oscillations on the SKEW in Sept - Oct - from 115 to 151:
http://www.barchart.com/chart.php?sym=$SKEW&t=LINE&size=M&v=0&g=1&p=D&d=X&qb=1&style=technical#
If this were a patient on the operating table, he would have died from extreme shock overload - think like sitting in an electric chair with the current being switched on and off in rapid succession.
These oscillations show professional money managers reacting to forces which are unknown to me. These are the manifestations of extreme discomfort and uncertainty.
The options markets have become the tail wagging the dog, and rises in implied volatility causes rises in real volativity and sell-offs on the equity markets.
The volatility shorters are crowding this market right now because there is a constant profit to be made, as long as the market is calm. And it has become easy because there are now instruments just for this. These instruments are hiding turnover from the options markets when everything is calm, because they can offset individual buyers and sellers. But when there is real volativity the backers of these instruments need to go out into the options markets big time, and then there is not enough liquidity for them, causing implied volatility to skyrocket, causing real volatility to also skyrocket and markets to fall.
This is the time to be contrarian and go long volatility, although it in calm markets is a loosing position. The chance of more and possible worse events like at the end of August is IMHO enough to warrant a long volatility position.
Personally I am quite cautious as an investor, and I have stayed out of the options markets. I am still cautious but I want to preserve my capital, even if it means I have to pay for it. So recently I bought put options to insure against losses in my equities, buying volatility. The time value of options falls with time, so I slowly loose money.
But as the article ends up saying: Sometimes it is better to know you will go bankrupt slowly than to not know if you might go bankrupt quickly.
Long VXX. Use as portfolio insurance and speculation. Have a GTC sell order at 44. If VXX spikes, when I am fishing, then I am out and will have to re-stake.
If it starts to blow up the Fed will step in.
This is the reasoning that makes so many be short volatility. But one day the Fed will not or can not step in, and that is the day investors long volatility will make up big time for the small daily losses they have.
Short VIX ETP? I'd feel more comfortable as a drunk, insomniac nitroglycerin delivery man with bad shock absorbers ...
God - I pray Tyler is correct..so be it.
In other news:
The meeting was held after the Central States Pension Fund told retirees that it is wrapping up work on what it calls a “necessary and fair pension rescue plan,” which it will file with the federal government.
The cuts that were outlined in a letter sent to him, Carroll said, would mean that his pension would be reduced from $2,800 a month to $600. - End
http://johngaltfla.com/wordpress/2015/10/20/teamsters-pension-fund-to-cu...
John Galt summarizes:
Prepare for a loud and possibly black swan style backlash as the union retirees and current members start to bail out of any union promoted investment program and demand the independence to vote on right to work laws in those states where the union exploitation has led to the demise of many a retiree’s nest egg at the most crucial and vulnerable part of their lives.
I typically don't like Artemis (especially that stupid moose for their logo), but this is a decent piece.
This is precisely the kind of inherent structural market weakness (similar to "portfolio insurance" via program trading in 1987) that can be exploited to great effect by astute market participants. I'm not saying my astuteness will be up to the task, but this is something that has definitely been at the back of my mind for some time - along with illiquidty in the underlying holdings of junk debt ETFs, another time bomb waiting to go off.
"Many retail investors simply do not understand that short and leveraged volatility ETPs rebalance non-linearly (see below). To the casual observer it may appear that short and long assets counterbalance one another but this is not the case. For example if the first two VIX futures move 20% higher the short volatility ETP providers must buy an estimated 33% more volatility (vs. 25% for long) to balance that exposure. The first rule of derivatives hedging is that you never hedge a non-linear risk with a linear tool."
Is it just me or does anyone else wonder about whole skyscrapers full of people peering at screens and executing orders for, or better yet, CREATING "financial products"?
I see similar giant buildings belonging to insurance companies, chock full of people, doing what? Nothing goes in or out of those buildings except people - WHO is paying them to do WHAT?
When I was small, giant buildings usually had THINGS coming into them (mostly raw materials, and sub-assemblies), and THINGS coming out of them (mostly finished goods).
The company I work for manufactures medical instruments, so I get that - we make stuff, and sell it.
I guess my concern is that the banking, insurance, and legal professions have come to represent a scary large portion of the U.S. workforce (and GDP), and if there will be some tipping point for that like there is for VIX, or is it really a sustainable model for a modern economy?