"Friends Don't Let Friends Buy VIX"

Authored by Peter Tchir via Brean Capital,

I would NOT be selling volatility here.  My title was dripping with sarcasm...

Selling Volatility Is Very Crowded and Dangerous Now

You know a trade is getting crowded when my parents start asking about it.  You know just how one sided something is when people think that even Chuck Norris can’t make money buying vol.

Last Week’s Spike in VIX has brought out nothing but sellers of volatility.  I think selling VIX is very crowded and fraught with danger.

SVXY Shares Outstanding

SVXY a short VIX ETF is up to $1.3 billion in market cap.  (it looks like it held about 30% of the open interest in the VIX September futures contract.

XIV Shares Outstanding

XIV, a short VIX ETN, has also seen inflows (though seems to be losing market share to SVXY) bringing its market cap to just under $1 billion.

So we have extremely large inflows into the vol selling ETPs.

UVXY Shares Outstanding

UVXY a double long VIX ETF is down to $275 million in market cap.  Shares outstanding dropped nearly 50% as profit taking (or smaller loss seeking) pulled money from the strategy.

VXX Shares Outstanding

VXX, an ETN, is still just above $1 billion in market cap.

So we have large outflows in the long VIX ETPs.

I think that the strategy of selling short term VIX futures is not only extremely popular, but that the recent spike in VIX encouraged a large number of investors that it was time to reload on the trade or enter into it for the first time – very crowded.

Speculative positioning in VIX having never been shorter...

Relying on ‘Bend Don’t Break” Is Dangerous

As far as I can tell, investors have adopted a “bend don’t break” view on VIX.  That is can go higher, but it will always ‘revert’ to the mean.  So longer term, you get back the losses and the steep vix futures roll kicks in.

VXX Shares Outstanding

VXX is up 800% since it was launched in late 2010.  SVXY, which was launched later is similar.

VIX Short Term Futures Index

The index that most of these funds track is down 99.8% or something since it peaked.  It is down virtually every year.

I believe that investors have now decided that selling VIX is the ultimate buy and hold strategy.

Can VIX Break?

Either this strategy “can’t lose” over time, or there is something wrong with the logic.

Let’s start breaking down the logic

The VIX Curve Is Not Particularly Steep Right Now

The difference between the second VIX futures contract (UX2) and the first VIX futures contract (UX1) is only 0.45.  That is well below the average historical difference – that means that the ‘roll effect’ is greatly diminished.  Sellers of vol will need to wait longer to recover from losses, then if the curve is steep – but that still fits into the ‘bend don’t break’ meme, rather than breaking VIX.

I want to highlight how inverted VIX becomes at times of stress. 

Every period of stress has involved a serious inversion.  The financial crisis saw the most extreme rise in VIX (as per the futures index value) but also had extreme inversion.

This is where I think I need to highlight a few things

The VIX futures contract just rolled this week, so the bulk of the exposure in the index is to the front contract (above 90% I think).  I think from a practical standpoint, and VIX ‘break’ will occur while the index is heavily skewed towards the front end – precisely because it shows a tendency to invert at times of stress (so if and when trying to time VIX breaks I would target periods where the contract is mostly in the front end)


SVXY was short 90,000 UX1 contracts.  The equivalent hedge for XIV is about 70,000 contracts (we do not know how CS hedges the exposure).  That would make those two indices with 160,000 UX1 shorts out of open interest of less than 300,000 contracts – well over 50% of the open interest in UX1 can be explained by these two ETPs.


These ETPs did NOT exist in 2008 – so I don’t see how you can rely on historical data back then.  In the past, VIX was merely an observable calculation (a complex one at that).  Now VIX is a tradable product in its own right – with daily rebalancing that tends to push it in the same direction that it moved throughout the day – plus all of the other technical that can occur when a product is traded – rather than just calculated.  I personally don’t trust the data even in 2011 since these ETPs were in their infancy back then – not the 800 pound gorillas they have become.


XIV terminates if the underlying index is down 80% in a day.  Poof.  Gone.  It will pay cash at whatever residual value is left after unwind.  If CS was simply hedging with the 70,000 futures contracts, that would cause immense demand for futures on what could only be described as a very nasty day (80% hasn’t happened – but these products didn’t exist).  SVXY is not explicit on what it does on a large move day – I suspect, that is part of the reasons inflows into SVXY are so much larger than XIV.  But, SVXY has margin agreements in place, and since it isn’t a charity, I would think that it shutters its doors at some level below down 100% (they can’t ask shareholders for more money, so the margin counterparties would shut down the trades.  If the trades don’t exist, I’m not sure how the ETF can).  So imagine that XIV knocks out, which triggers a VIX spike, which knocks out SVXY.  It seems incredibly unlikely, but then again AIG was ‘AAA’ and ‘super senior’ was super safe.  Housing prices, on a national basis, had never declined.  Lots of ‘impossible’ things seem to happen once financial engineering drives them too far.  What is really perverse, because I can’t think of a better word to describe it, is that for everyone who would be looking to sell vol when it hits 25 or some high number wouldn’t be able to – because the two easiest ways – buying these ETPs wouldn’t be an option.

Yes, VIX can break.  It is highly unlikely, but not impossible. 

What To Do?

I would NOT be selling volatility here.  My title was dripping with sarcasm. 

I like buying VIX calls here – even something that seems as unlikely as a 20 strike.  Pure ‘lottery’ ticket type of trades.

When I wrote this weekend that I thought VIX would hit 20 before 10, I was extremely nervous as VIX collapsed on Monday as North Korea backed down.  My bad case, that I laid out in Sunday’s report – does, unfortunately, seem to be gaining traction – and I think selling VIX is very crowded and might disappoint those who entered the trade recently.  There is plenty of room for some fund flows into the long VIX products like UVXY – which is the most dangerous in both directions as it rebalances daily – constantly adding flows to the directions it already moved.

Keep an Eye on Risk Parity/Vol Targeting Strategies

There might be nothing to it, but treasuries and stocks were both weak this morning.  Once the Cohn headlines hit and were then retracted, stocks remained near the lows while treasuries quickly eased off on some of the gains (the long bond is lower on the day again).

Realized Vol Is Increasing in Risk Parity Strategies

This is one fund that I track and realized vol is nearing its highest for the year.

I think that most sophisticated Risk Parity strategies had plenty of cushion in terms of vol and correlation before needing to sell assets – but as we remain at what now passes as elevated vol – we should keep an eye out for any signs of flows from these strategies – where weakness in both long dated sovereign debt and equities is the biggest risk (some commodity weakness wouldn’t help matters).

I doubt we are seeing anything meaningful from Risk Parity but it is worth watching.