Market Volatility Has Changed Immensely

Volatility is not what it used to be.

How Volatility Is Helping Hedge Funds

On Aug. 24, as global markets fell precipitously, one thing was shooting up.

The Chicago Board Options Exchange's Volatility Index, the VIX, briefly jumped to a level not seen since the depths of the financial crisis. Behind the scenes, however, its esoteric cousin, the VVIX, did one better.

The VVIX, which measures volatility in the VIX, reached a multi-year high.
The VVIX, which measures volatility in the VIX, reached a multi-year high.
Source: Societe Generale

For years, the VIX has been Wall Street’s go-to measure for expected stock market volatility. Derived from the price of options on the S&P 500-stock index, the volatility index has evolved into an asset class of its own and now acts as a benchmark for a host of futures, derivatives, and exchange-traded products to be enjoyed by both big, professional fund managers and mom and pop retail investors.

The dramatic events of last month underscore the degree to which the explosion in the popularity of volatility trading is now feeding on itself, creating booms and busts in implied volatility. Even as the VIX reached a post-crisis intraday high, the VVIX, which looks at the price of options on the VIX to gauge the implied volatility of the index itself, easily surpassed the levels it reached in 2008.

Analysts, investors, and traders point to two market developments that have arguably increased volatility in the world’s most famous volatility index, beginning with the rise of systematic strategies.

The amount of options and futures tied to the VIX has risen in tandem with the popularity of volatility trading.
The amount of options and futures tied to the VIX has risen in tandem with the popularity of volatility trading.
Source: Societe Generale

Such strategies fall under a host of names that include commodity trading advisers (CTAs), volatility overlays, dynamic hedging, and risk parity*, though it's worth noting that many types of buy-side players have been dabbling in such techniques as they seek to boost returns in an era of historically low interest rates and suppressed market moves.

When there's a sudden spike in volatility, as occurred last month, the price of near-term VIX futures rises. Meanwhile, volatility players — notably hedge funds and CTAs — scramble to buy protection as they seek either to hedge or cover short positions, causing a feedback loop that encourages near-term futures to rise even further.

CFTC data shows a big swing in net (non-commercial) VIX futures positioning.
CFTC data shows a big swing in net (non-commercial) VIX futures positioning.
Source: Bloomberg

That behavior was evident last month, according to Ramon Verastegui, head of flow strategy and solutions for the Americas at Société Générale. He has pointed to net speculative positions in VIX futures as a proxy for short covering. The data show the contracts jumping from negative 53 million on Aug. 18, before the worst of the recent market turmoil, to 16 million on Aug. 25. That suggests a large (almost 70 million) reversal in positioning and a classic short squeeze as traders were forced to close their bets against volatility amid seesawing markets.

The proliferation of exchange-traded funds and notes that allow investors to bet on the future direction of the VIX has arguably exacerbated the VIX's movements. Bloomberg News reported late last month that the amount of assets held by volatility-related exchange-traded products has jumped, from practically nothing less than a decade ago, to $4.3 billion currently.

Many of these new products exacerbate VIX moves, thanks to a technical quirk in the funds' efforts to rebalance portfolios, which sees them tend to buy VIX futures when the VIX is moving up and sell futures when the index is trending down.

“This rebalance volume can be quite significant and can amplify VIX futures moves to the upside and downside, which is one reason why the VVIX, or vol-of-vol, is higher these days than even 2008,” said Pravit Chintawongvanich, a New York-based derivatives strategist at Macro Risk Advisors.

According to JPMorgan Chase analysts led by Nikolaos Panigirtzoglou, retail investors have, in the aftermath of Aug. 24, sold VIX ETFs that reward them when market volatility rises and instead piled into inverse VIX ETFs which reward if volatility falls. Like volatility players buying near-term VIX futures when turmoil spikes, the influx of money into inverse VIX products is said to intensify movements in the futures, helping to change the customary shape of the VIX futures curve.

Source: JPMorgan

"The effect is a surge of buying in the first few days after the [VIX futures] curve inverts — again, exacerbating the inversion as they mainly buy the very front end of the curve," said Chintawongvanich. "Likewise, when they all rush out, this exacerbates the speed of the collapse. It's not too dissimilar from portfolio insurance in the 1980s."

SocGen's Verastegui noted that the panic buying of VIX-related options and futures on Aug. 24 means that speculative investors, including hedge funds and CTAs, have now built up long positions in implied volatility that are even higher than those recorded during the financial crisis of 2008.

Source: SocGen

That could herald even more volatile times ahead for the world of volatility trading.

"This opens up a couple of key questions," said SocGen's Verastegui. "How much further the VIX can go up? And, if the market starts unwinding, then should we expect a big volatility collapse?”

*Risk parity funds — which rebalance their portfolios as actual market volatility increases — don't necessarily dabble in VIX-related futures or options. Instead they tend to exacerbate realized volatility because they automatically sell off stocks and bonds and increase cash positions during market turmoil.

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