Remembering LTCM

The VIX Spike Deserved to Happen

Though, just maybe, there's scope for a return to normal.
Jim Young/Bloomberg via Getty Images

The Chicago Board of Options Exchange volatility index has just witnessed the biggest percentage move in its history. This is no flash crash but a rude lesson in riding a comfortable trade for too long. What's ruined this was that stocks rose too fast at just the same time that 10-year bond yields had an absolutely miserable start to 2018. 

Being short volatility has been a winning trade for years, but central banks telegraphing that they are about to leave the room is a sure sign that change is coming. Liquidity withdrawal and being short volatility are not natural bedfellows. The only practical way to reduce exposure is to short the S&P 500 index itself -- which leads to a doom spiral of everyone exiting at the same time. 

We Saw You Coming

Surging stocks, collapsing bonds, and being short volatility did not combine particularly well

Source: Bloomberg

Intraday times are displayed in ET.

Those with long memories will recall that it was a sharp upward spike in volatility that proved fatal for Long Term Capital Management. The fund was short volatility pretty much everywhere it could be, and then the Russian debt crisis scuppered all their plans -- and their access to liquidity along with it. Anyone in this market who has not learned this lesson deserves what they get.

Is everyone finished hedging out their short volatility trades? It's hard to know. The most-exposed in the current case, the short volatility ETNs, are probably finished. However, risk managers around the world are going to be looking very hard at their value-at-risk models, and trying to work out what they've missed, and how to plug the gaps. 

That's It

This Credit Suisse short VIX ETN has lost almost all its value -- and it will surely not be alone here

Source: Bloomberg

Note: VelocityShares Daily Inverse VIX Short-Term ETN, Bloomberg ticker XIV US

Oddly, there's an argument for thinking this is probably the best time to short volatility -- right after a spike, as history shows. The catch is that you have to believe this is not a repeat of the financial crisis, when volatility stayed elevated for over a year, but just a much-needed correction. 

This looks like a position-driven shakeout. The turmoil is due to people being caught in positions that had worked for ages and now don't -- it's not the result of a one-off event. This suggests that there's scope for normal service to resume once the period of managing the spiral has passed.

At some point when the dust settles everyone is going to have to look into whether this vast range of short volatility products should have been allowed to multiply unchecked. But the dust is still flying. 

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

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