VVIXtermination: What Was Behind Yesterday's Historic Volatility Quake

If Feb 5, 2018 was the infamous inverse VIX ETF "volmageddon", then May 7, 2019 was the "VVIXtermination" event.

Following an overnight Reuters report , according to which late last Friday China reneged on nearly all aspects of the trade deal that had already been agreed upon previously, "with systematic edits to a nearly 150-page draft trade agreement that would blow up months of negotiations between the world's two largest economies" as "China had deleted its commitments to change laws to resolve core complaints that caused the United States to launch a trade war: theft of U.S. intellectual property and trade secrets; forced technology transfers; competition policy; access to financial services; and currency manipulation", the Friday midnight imposition of tariffs looked like a near-certainty, sending futures sharply lower... at least until Trump threw algos for a loop once again on Wednesday morning when he tweeted that "China has just informed us that they (Vice-Premier) are now coming to the U.S. to make a deal."

Still, confusion is rampant, and after one of the worst selloffs of 2019, Nomura's Charlie McElligott writes this morning that "as funds have become more dynamic/sophisticated with their unwinds (to reduce their often-times ‘heavy handed’ / price-insensitive de-risking)", there will likely be additional days-worth of deleveraging flow both from:

  1. The massive Asset Manager ongoing de-risking / profit-taking in their previously highlighted US Equities Futures “Longs” as well as
  2. Trend “Longs” in SPX also reducing (which triggered yday and sold down from +100% to +60%, as the signal flipped in 2w and 1m models)—plus
  3. The FUTURE risk of new tariff-related headlines which in-turn could dictate mechanical de-risking driven by Vol Targeting strategies in the coming days, majority of whom have yet to mechanically- or dynamically- de-leverage without another few days of ‘sticky vol,’ which then can “pull” trailing realized higher (e.g. SPX 20d realized still below 10 tgt, which is generally ‘benchmark’).

Yet while the December selloff was far longer and more intense, by at least one measure yesterday's furious dump on the unexpected collapse of the trade deal, matched - if not was stronger than - the December mini bear market, and nowhere was this more obvious than in the previously discussed explosion of the VVIX, or vol of vol, index.

In fact, as McElligott writes today, this has been the "second largest three-day move inb VVIX/VIX ratio since the Feb 5, 2018 leveraged short VIX extinction event (only behind the "Mnuchin Christmas Massacre" of Dec 24th 2018): There will never be another Feb 5th (bc that ‘short vol’ rebalancing supply from the leveraged VIX universe will never recover to prior levels)…but this was a good one.

There is another aspect to this week's violent move higher in the VIX: the extreme skew in the VIX confirms the outperformance of VIX vs S&P; i.e. per the previous two year lookback as “standard,” yesterday’s SPX performance “should have” seen VIX close at 15.95—but instead, it closed at 19.32 (and +47.3% WoW), which to McElligott, "captures the relative extremes of the “short vol” unwind which behind the VIX futures curve inversion."

Incidentally, this is precisely what we warned about this Sunday, in "Is The VIX About To Explode Higher Thanks To A Record Short Squeeze."

This violent repricing of volatility has gotten McElligott thinking several steps ahead, and he is already discussing how to trade what's coming next. As he notes, while "it is still too early (because the tariffs being slapped-on Friday at midnight will Equities off further / risk further Vol squeeze as market is still in “crash DOWN” not “crash UP” mode—SEE VVIX and upside skew at 3% / downside skew at 81st %ile / ratio of 25d put and 25d call skew 91st %ile)—we are inching-ever-nearer to the time to start thinking about tactical expressions to capture Equities upside via options (although at this moment, ‘selling puts’ likely far more attractive than ‘calls,’ which look outright awful) in order to take advantage of this amazing ‘rich vol’ market backdrop." but again, "just not quite yet." We are confident the Nomura strategist will say "when."

One more observation from the Nomura strategist, and this has to go with how to best hedge yesterday's historic volatility explosion. According to McElligott the right trade here is Eurodollar futures, whose "upside look like smart protection, as Rates/USTs are working as a hedge during the Equities vol spike (Risk-Parity doing its job), with the additional ‘kicker’ that the more the US/China tariff- and trade- dynamic devolves, the more likely the market is to price-in the likelihood of “dovish Fed” and/or rate cuts (Fed is cornered into “asymmetric” policy—much lower bar to “ease” than to “hike”)."

In parting, here are a few more observations on yesterday's market action, straight from McElligott:

  • As per earlier mention and despite silly headlines later from financial media, yesterday’s bounce into the close (and the initial overnight follow-through) was NOT about some sort of tariff / trade “calm” or “optimism”—it was instead the result of 1) long vol / short delta monetization (both from hedgers and front-runners of the anticipated systematic deleveraging trade) and in the larger sense, 2) an environment where funds / traders are forever incentivized to sell into spikes in volatility
  • Tactically-speaking, it was ‘vol longs’ (whether ‘Long’ VIX ETN owners or dealers who were sold volatility from buyside) and / or ‘short delta’ (e.g. dynamic hedgers OR even traders who were looking to front-run the Systematic Trend flows) looked to lock-in positive pnl yesterday afternoon as the tape cratered late, they turned the tape in the final 30 minutes via their profitable unwinds (sell some of their ‘long vol’ / cover their ‘short delta’)

This, in turn brings us to what McElligott calls the "larger/existential question": why does this now almost quarterly “short vol/easy-carry/easy-carry/easy-carry BLOW-UP then v-shaped snapback” seemingly occur now more-than-ever before? Our answer: central banks, and McElligott agrees:

"IT’S PURE MINSKY of “stability breeding instability”--I will happily pin-this on the post GFC Central Bank policy response of large-scale-asset-purchases (LSAP) and forward-guidance on “lower interest rates and flatter curves forever” which has then perpetually suppressed cross-asset volatility AS WELL AS squelched yields—all in order to create notional “financial repression” which drives “portfolio rebalancing"

As such, Real Money institutions have moved from being BUYERS of volatility and tail-risk hedges to instead turn VOL SELLERS in the post-crisis period (systematic call overwriting / put underwriting, condor- and strangle- selling, roll-down etc)—all in order to generate total return / “yield enhancement” in a world deprived of return.

McElligott's conclusion: "As a friend wrote yesterday: “If you’re short vol, you make money…but eventually die.  But if you’re long vol, you die before you make money."

There is third alternative: you're short vol and you do make money. The problem is that since central banks have now staked the very concept of fiat money behind their vol suppression strategy, the money you make will soon be worthless.