Many market agents seem vexed by the VIX. Their recent lessons include a dramatic spiking of volatility, the reactionary pricing of an exchange-traded note (ETN), some forced liquidation, and a blisteringly fast correction in stock prices. The average stock dropped 14% in only a few weeks. Everyone following the investment markets in the US knows the headlines, so we won’t repeat more of them here.
I had a conversation about these events with Jon Ferro and Gina Martin Adams on Bloomberg TV at 9 AM on February 12. On the set with us was Pravit Chintawongvanich, head of derivatives strategy at Macro Risk Advisors. The VIX was on our minds.
Pravit was kind enough to allow us to quote his work and views:
• “The wipeout of the short VIX ETPs should lead to lower vol-of-vol, and more stability in the VIX futures market.
• “Significantly smaller VIX rebalance should lead to lower realized vol in VIX futures and lower implied vol in VIX options.
• “A dynamic source of ‘vol supply’ may have disappeared as previous XIV/SVXY investors may no longer be as keen to sell vol.
• “The blowup in VIX products was largely localized to VIX, with little spillover into FX, rates, or commodity volatility.”
Pravit discussed the mechanical details with me off camera and described them in his Bloomberg TV interview with Jon. Here is his outlook for the post-VIX crash results:
“With the short VIX ETPs all but wiped out, a major source of instability and ‘blowup risk’ in the VIX futures market has disappeared. The short VIX ETPs were exacerbating moves in VIX futures through their daily ‘rebalance’ trading – buying VIX futures on days when VIX was up, and vice versa. Since the VIX ETPs had to buy increasingly many VIX futures as VIX rose, this sent them into a vicious cycle where they pushed vol up, in turn needing to buy even more – causing the ‘VIX blowup’ that we have predicted in many earlier notes. While other levered ETPs continue to exist, the size of this potential rebalance is significantly smaller after the destruction of XIV and SVXY…. On a +4 point move in VIX futures, the ETPs had to buy over 140,000 VIX futures on close. After the blowup, that number has shrunk to a mere 20,000 – back to early 2013 levels.”
Following the show, I asked Pravit about “tracking errors” in the crash and in the after-market trading. His view is that this activity was not a tracking-error issue. The influences included the participation of “retail investors” who may not have had the full skillset to understand what they were doing. Pravit responded:
“Good meeting you on the show this morning. I wanted to provide a little more color on how the inverse products performed last Monday (I paraphrased it to not get overly technical on TV). While the ETF, SVXY, performed as it should have during the equity trading day, XIV actually started trading at a significant premium to NAV (it did not go down as much as it should). After the equity close at 4:00 p.m. but going into the futures close at 4:15, these products both decoupled significantly. At 4:15 PM, the net asset value of XIV was $4.22, but the ETN itself was still trading at over $70! In fact, even at 8 PM when after hours trading closed, it was still trading at over $15.”
Pravit’s outlook for the future is clear:
“With the blowup of XIV and SVXY, an entire class of (mostly retail) investors may have soured on ‘short volatility.’ Even though SVXY still exists as an ‘easy access’ vehicle for shorting volatility, one would think the appetite among the ‘XIV crowd’ is significantly lower post-blowup (we have also heard anecdotally that many retail investing platforms are not allowing clients to buy SVXY anyway). These investors emerged when vol spiked and acted as a source of supply to meet volatility buying demand, potentially causing vol spikes to reverse themselves more quickly than they would have otherwise. This dynamic source of supply will no longer play as large of a role in helping to neutralize vol spikes.”
Pravit also sent along a link to a podcast he recently recorded, with this note:
“If you're looking for a finance podcast to listen to this weekend, I was on this week’s ‘Odd Lots’ to walk through the dynamics of the short vol trade, and how two of the biggest ‘short VIX’ products blew up in a single day. It’s a 30-minute listen and a nice high level overview of what happened.”
Here’s the link to his podcast.
We add one other viewpoint of our own.
The VIX became ubiquitous. It was a fixture in the lower-right-hand corner of the financial TV screen. It appeared every day in the headlines. It got nicknamed the “Fear Index”. In our view the VIX became subject to Goodhart’s law, named for Bank of England Governor Charles Goodhart. The law posits that when no one is focusing on an indicator, it has predictive value; but when everyone is looking at it, it has lost its efficacy and will be, at best, a contemporaneous measure. Thus the VIX is now worthless for predicting the future and questionable for explaining the present. It is reactive, not predictive. Hence any derivative of the VIX has a similar risk profile. Retail investors may have reached this new understanding the hard way.
We thank Pravit for permission to quote him and his work. And we thank Jon Ferro and the Bloomberg TV producers who were kind enough to include me in the discussion with Pravit and Gina.