Earlier today we pointed out a surprising warning from Tom McClellan, who when looking at the unprecedented surge in the shares outstanding of the VXX, also known as the long VIX ETN, pointed out that this product is suddenly extremely popular and asked "Can this possibly end well?"
The reason for his concern was based on a post he published a few months ago, in which he explained that "VXX Shares Outstanding Data Work Differently."
Curiously, at roughly the same time, Goldman's derivatives team released a note seeking to "asses the risk-reward of long VIX trades" in which it attempted to answer when is the right time to get long the VIX.
In the note, author Krag Gregory writes that "after averaging 24 from early January through the market low on February 11, the VIX has averaged 16.2 (14.2 in April). Is a VIX level in the low to mid-teens too low?" Goldman then notes that courtesy of complacent central banks, there is a lack of near-term catalysts for the VIX to spike and says "this potentially leaves the market with a relative dearth of short-term catalysts, and we continue to think that the VIX may remain range-bound over the next few weeks."
However, here Goldman noticed something peculiar, which ties in with what Tom McClellan pointed out overnight:
Our view that the VIX may remain low in the near term is at odds with the VIX ETP market, as investors seem to be pouring money into levered long VIX ETPs.
In other words, despite the eerie market calm manifesting itself in a plunging VIX and steadily rising market, Goldman has found a relentless inflow of cash into various VIX derivative products, which oddly enough does nothing to actually move the underlying price; and, as a reminder, these are all VIX-derived products which would lead to substantial payoffs in the event of a market crash due to the embedded leverage as most are vega-focused and bet on the volatility of the underlying volatility in the very near term.
This is what else Goldman has found:
- As the VIX has declined, the demand for VIX ETPs that benefit from a rise in market volatility remains strong, in particular double-levered VIX ETPs such as UVXY and TVIX
- In April 2016, the market cap of the UVXY topped $1bn for the first time and vega exposure on the UVXY remains near an all-time high at around 120 million (Exhibit 1). The markets two most popular double levered longs are the UVXY and the TVIX. Their combined vega exposure recently stood at around 190 million vega, about twice the vega in single-levered long products such as VXX and VIXY (Exhibit 2).
- Short vol performance… +73% since February 11: While long ETP exposure has been growing, the appetite for inverse VIX ETPs, which benefit from declines in volatility such as the XIV and SVXY, has been muted, with vega exposure remaining range-bound in recent weeks. That’s surprising, since the benchmark index which these underliers track (SPVXSPI) is up 73% since the market low on February 11 and investors often follow performance!
The underlined text is key as it goes to the heart of McClellan's argument, namely that while investors typically chase performance (and momentum) in the case of the number of shares outstanding in the VXX, or the now record vega exposure across the VIX derivative sector. And furthermore, as McClellan showed, unlike other trading instruments, interest into VXX (or respective vega exposure) is a "double-contrary indicator." Oddly enough, at previous peak, it has tended to lead to major downward inversion points.
As for Goldman's punchline:
Vega exposure on longs has tripled since February 11: The total amount of vega exposure across four popular long VIX ETPs (VXX, VIXY, UVXY, TVIX) has tripled since February 11 and recently stood at ~290 million, a record high.
And this is what this flood into vol vega-exposure looks like graphically across the various products that allow investors to bet on an imminent spike in volatility.