The "Wipeout Scenario": 250% Losses If VIX Spikes To 20

By Francesco Filia of Fasanara Capital

How Bad a Damage If Volatility Rises: The Bear Trap of Short Vol ETFs

As if there was any need for any more threats to financial stability in a world overburdened with debt facing rising interest rates on bubble valuations in both bonds and equities, within an environment dominated by economic policy shifts and political gridlock, there is a potential bear trap right in today’s most fashionable investment products, which risks deflating fast: Short Vol Exchange-Traded Notes and, more broadly, volatility-driven investment vehicles. In this note we will discuss briefly the former. A full analysis and access to our data room is available upon request.

Years of Central Banks’ hyper-activism, financial repression and regular bail-out of financial assets led to a collapse in volatility, and the ensuing investment mania in volatility-driven strategies: risk parity funds in primis, vol-levers of all types, but also exchange-traded notes directly linked to volatility. Among these, Short Vol ETFs have grown relentlessly, oftentimes including leveraged plays, oftentimes sold to retail, fully or partially un-aware of how quick wipe-out-type risks can materialize on such products, and how close we got to such wipe-out risks. For the purposes of our scenario analysis, we will define a wipe-out risk as one of losing more than 75% of the original investment.

We find that the total size for vol-linked ETFs, after leverage and Beta-adjusted is almost $40bn.

The conventional wisdom goes that VIX has never historically moved up so much and for so long as to wipe-out short vol strategies. It would typically require a doubling up of VIX in short order, which has never occurred on a daily basis across modern history.

However, as VIX drags itself around rock-bottom historical levels, often at sub 10-levels, while equity valuations are the highest in history, the risk of volatility doubling up is today materially higher than it has ever been. If VIX was at 20, to double up it would have to move to 40: a statistical outlier. But VIX trades around 9/10 now, from where doubling up simply takes it to 18/20 territory, which is actually spot on the average for VIX on recorded history since 1993 (while median is 15.95). VIX was actually higher than that 30% of the times. If and when it happens, such ETFs would suffer dramatic losses. For wider moves than that, some of the volatility-linked instruments would be almost wiped-out. In others, where a short-vol position can easily be extracted by shorting a leveraged long-vol exchange-traded note, the investor would stand to lose up to 650% of the capital invested.

It is one thing for short-vol ETF to be exposed to rising levels of volatility up to the point where they face wipe-out event risk. Any investment can go sour, and even very badly so. It is quite another for such small moves in volatility to be enough to trigger a wipe-out event. What strikes is then how close we drifted to the cliff, thus with how big a probability it will happen at some point down the line. Indeed, doubling up from where volatility stands now is easy, and simply means moving towards historical averages.

We performed an analysis on some of the largest notes linked to volatility, both from an historical perspective (Regression Analysis) and taking into account the sensitivity of the specific note (Formulaic Analysis). Our analysis shows that if VIX goes from 9.60 to 18/20 in absolute values (it was approx. 40 as recently as Aug2015), and stays there for 8 / 10 days in backwardation, VIX-based ETFs may stand to lose up to 55%. Short positions on long-vol ETFs can then lose up to 250% of capital with VIX at 20. Losses are higher in case of wider backwardation of the term structure of the VIX (i.e. front contracts trading higher than back contracts), or the longer VIX stays elevated while in backwardation, or clearly the higher it goes. For example, if VIX quadruples from here to 40, losses on a UVXY position would amount to a staggering 656%!

Additional risks arise as ‘liquidity gates’ may be imposed, even in the absence of a spike in volatility. In 2012, for example, the price of TVIX ETN fell 60% in two days, despite relatively benign trading conditions elsewhere in the market. The reason was that the promoter of the volatility-linked note announced that it temporarily suspended further issuances of the ETN due to “internal limits” reached on the size of the ETNs. Furthermore, for some of the volatility-linked notes, the prospectus foresee the possibility of ‘termination events’: for example, for XIV ETF a termination event is triggered if the daily percentage drop exceeds 80%. Then a full wipe-out is avoided insofar as it is preceded by a game-over event.

The reaction of the investor base at play – often retail – holds the potential to create cascading effects and to send shockwaves to the market at large. This likely is a blind spot for markets.

To be sure, low volatility has further ramifications above and beyond short-vol exchange-traded notes. An artificially low volatility environment, generated by the passive flows of Central Banks (in excess of $300bn per month at present) and rule-based investing vehicles (we count almost $8trn at play today between risk-parity, vol-levers, ETFs, passive index funds), breeds market fragility. It may well represent the calm before the storm. A state of persistently low volatility offers the fiction of innocuous, ever-trending markets, which entices new swathes of unfitting investors in, mostly retail-type ‘weak hands’. Weak hands are investors who are brought to like an investment by certain characteristics which are uncommon to the specific investment itself, such as its featuring of a low volatility. It is in this form that we see bond-like investors looking at the stock market for yield pick-up purposes, magnetized by levels of realized volatility similar to what fixed income used to provide with during the Great Moderation. Weak hands investors are the first to leave should the low-volatility regime shift gear, adding to the fragility of the market. We discussed it here.

Market fragility must surely be a concern in the current investing environment. Yet, the psychological damage on investors and their behavioral reaction function to a sudden risk-off environment can never be as certain and direct as a wipe-out risk to a whole cluster of them. That is the nature of the risk that short-vol vehicles are facing today.

A synopsis of the data analysis follows below.

Frequency of VIX at different levels: 30% of the times in the last 25 years VIX printed above 20

Mean VIX on recorded history since 1993 is 19.63
Median VIX is 15.95


Fat Tail of VIX distribution: 

Extreme returns on VIX are more frequent than a normal distribution would project, as confirmed by the Shapiro-Wilk reject of the null hypothesis of normality. A cursory look at the shape of the returns distribution of VIX shows high Leptokurtosis. This is reflected in the frequency with which VIX has doubled up, in a window of just 14 days: 6 times in the last 9 years.

Regression Analysis and Formulaic Analysis of a few major volatility-linked ETNs

Losses can compound fast for moves in VIX which are both relatively small and frequent in history. According to both an historical and a formulaic analysis, Vix at 20 implies losses up to ~280% across instruments, depending on the shape of the term structure (contango vs backwardation) and how long a period the drift and shape are sustained for.


Case Studies:

August 2011: (XIV) VelocityShares Daily Inverse VIX Short-Term ETN
XIV lost almost 75% of its value when the VIX rose from 18 to 45 during the month



August 2015: (UVXY) ProShares Ultra VIX Short-Term Futures ETF
During August 2015 VIX climbed from 12 to 40 in just a few days, on fears of China’s devaluation. A short-vol position in UXVY (short the note) would have lost 100% of its capital already as VIX traded at just 25. It ended up losing 270% as VIX was nearing 40.

May 2010: (VXX) iPath S&P 500 VIX Short-Term FuturesTM ETN
UVXY is a leveraged instrument, but unlevered short volatility strategies can have large swings too. During May 2010, a short-vol position in VXX ETN would have experienced a loss of 82% of the capital.

Comments

Mr 9x19 jcaz Thu, 07/20/2017 - 14:36 Permalink

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In reply to by jcaz

thesonandheir Mr 9x19 Sat, 07/22/2017 - 19:23 Permalink

Begs the question - why is a sophisticated cunt like Soros underwater by trying to short this market? Why does the old cunt not just take a massive short position in the inverse volatility XIV and force the ETN to purchase VIX which would blow the algos out of the water? As I understand it the VIX down is a buy signal for the wider market, it cannot move at the minute because these short vol products are so popular and forcing it down.

In reply to by Mr 9x19

GUS100CORRINA Uncle Tupelo Thu, 07/20/2017 - 14:21 Permalink

The "Nightmare Scenario": Up To 656% In Losses If VIX Spikes To 40My response: If one looks at a monthly chart of SQQQ, TVIX, SDS, DXD, TZA, QID, etc., one only has to ask the question:WHAT IF THESE CHARTS ARE REVERSED?What if rather than declining in an exponential pattern, these charts increase in an exponential pattern? See chart below as an example of one of the ETFs listed above.http://www.finviz.com/quote.ashx?t=SQQQ&ty=c&ta=0&p=mWe are in unchartered waters.

In reply to by Uncle Tupelo

OliverAnd Thu, 07/20/2017 - 14:20 Permalink

With the amount of destructive power each nuclear bomb carries, I think the North Koreans can afford to be a couple of miles off target don't you think?

Peak Finance Thu, 07/20/2017 - 14:29 Permalink

Not a reailty-based articleAfter the third day of huge losses, there would be tons of secret meetings and every back-door dealer (high level pols and huge CEO's)  would call in either favors, bribes, deals or threts, and the Fed would step in BIG-TIME. Tell me instead how possibly the Fed would / could lose control?It's hyperinflation all of the way now, it's baked-in. Only senario I can think of where the Fed loses control is the loss of reserve currnecy, and, gues what? That ends in hyperinflation as well.  

Vlad the Inhaler Thu, 07/20/2017 - 14:31 Permalink

If you're going to short VIX at least use XIV/SVXY, or buy puts on VXX/UVXY, in that case your loss would be limited to 100%.Although I read that the biggest losses during a crash by far are the guys doing calendar spreads on the VIX futures options.

xrxs Thu, 07/20/2017 - 14:42 Permalink

I've been wondering about this scenario, but haven't had the time to do the math. VIX 18 to 20, backwardation for about 8 days.  That's not even a black swan's worth.  That's like USDCNY at 7. I think some of these products have broken the VIX and the exit door is going to get pretty crowded when the time comes for mean reversion.  Will be watching with popcorn in hand.

mo mule Thu, 07/20/2017 - 14:42 Permalink

So if I go long UVXY options with the VIX at 9.60 and the VIX goes to the norm say 20 I could make 250% or is it 650%?Well when the Fed's raise % a quarter next week I'd be in the money. /sOr when Trump bomb's NK for no reason, like he did Syria a few months back, then WW3 would be on and I'd be in the money.  /sOr when Yellowstone blows up sometime in August or September and the VIX goes to 100, I'd be in the money.   /sOther than that, what could go wrong?    /s  

gm_general Thu, 07/20/2017 - 15:00 Permalink

VIX is in a downtrend where the resistance line starts at Jan 2016 high, connecting to Bexit high and election high. This line is just over 17 now and dropping about 2 points every 3 months. IMO if it breaks that line to the upside, perhaps in October, all hell will break loose and you will get your monster spike. All you would have to do then is break over 15 or so.

Heliotential Thu, 07/20/2017 - 15:49 Permalink

If one does the backtesting, they would see that entering into vix etn shorts and the like when vix was at actually at high levels, they'd be near immune to losses. 

nsurf9 Thu, 07/20/2017 - 16:21 Permalink

I can see how you can get a 250% increase, but how do you get past that first 100% loss, seriously, cause the $20 UVXY I bought and made some money on in late 2015, show they are now worth $3,000 (via inverses) and will never go past zero. Seriously, only short or stay for only a short while, as these ETNs, due to the decay of the underlying options, by itself, will make them worthless over time.

Non-Corporate Entity Thu, 07/20/2017 - 16:18 Permalink

250% loss?!?!? That's like killing someone, bringing them back to life, killing them again, and then bringing them back again just to kick them in the balls with a metal boot until they beg you to kill them...again!

HermanVanCuckold Thu, 07/20/2017 - 17:01 Permalink

Everybody knows this scenario set out in the article, but I'm not sure how a small trader is supposed to take the other side of the trade and not get killed due to time decay of those instruments or putting on an option trade month after month.

I wonder if maybe the better idea would be to look at second or third order effects of a volatility spike and put those trades on instead. A gold or silver call option mentioned in another example could be one, but we could probably think of others.

xrxs HermanVanCuckold Fri, 07/21/2017 - 02:21 Permalink

I've got a couple ideas - long dated low strike puts on short ETFs (I priced these out a while back and wasn't very excited), or make sure I get long after a black swan or some other exogenous event just before the Volkswagening begins.  Statistically, there's something abnormal about the current VIX situation. My thought is that after so much ZIRP, buyers are PE insensitive (like the .com days). In this world, buying pushes VIX down, which is used as a buying signal, which pushes VIX down (and so on, until such time as the dry powder and margin fuel is used up, or an exogenous event changes participants' expectations).  This is going to be tough because there may be a certain working group that may try to keep this thing flying or at least land it softly.

In reply to by HermanVanCuckold