Volatility Traders Have a Big Problem: Themselves
Here is the Chicago Board Options Exchange Volatility Index, better known as the VIX.
After surging to a multi-year high in August, the index has now plummeted back to earth.
In fact, the so-called term structure of the VIX has returned to its norm, after inverting during that month's dramatic stock market selloff. The forward curve of VIX futures has since reverted to its usual shape of sloping gently up. (The price of real-time, or spot volatility, normally sits below the price of later-dated futures, reflecting the possibility that something bad will happen between now and then.)
Yet all is not necessarily well in VIX-land, as analysts and investors debate the index's recent extreme movement. Some argue that the explosion in the popularity of volatility trading is now feeding on itself. The rise of volatility-related strategies and exchange-traded products is laid bare in a new report from Chris Cole, founder of the Austin, Texas-based volatility investment-management firm Artemis Capital. He contends that the era of central bank-induced complacency may have created a wild new market force.
"The great unknown is that this massive short volatility animal that appears tame given a regular diet of central bank liquidity may turn wild when that liquidity is removed," he wrote in a research note (PDF).
At issue is the degree to which low interest rates and unconventional monetary policies from the world's central banks have encouraged investors to sell volatility as a way to prop up returns while they bet on the continuation of the so-called central bank "put." The strategy has paid off in recent years.
"Global central banking has artificially incentivized bets on mean reversion resulting in tremendous demand to short volatility," Cole said. "As the short and leveraged volatility complex becomes more dominant it is contributing to dangerous self-reinforcing feedback loops with unknowable consequences."
The returns on offer from selling volatility have lured a host of participants to the strategy, with everyone from large asset managers to retail investors using a variety of volatility-related structured products to short-sell VIX futures alongside more traditional "vol sellers," such as banks and hedge funds.
But as the punch bowl of the central bank put is taken away, the chances of the strategy going awry increase, a risk heightened by the preponderance of volatility sellers who have been shorting the VIX. And while Cole talks of "unknowable consequences," he has a particular "black swan" scenario in mind.
He foresees a sudden market event that forces the VIX up sharply, causing a wave of hedging by traditional volatility-sellers who—thanks to structural quirks in the way they trade—are then forced to buy VIX futures. That could spur volatility sellers to buy a bevy of alternative financial instruments as they desperately seek to rebalance their portfolios.
"The VIX futures market may struggle to absorb the demand for long volatility and dealers would be forced to rely on other sources for forward volatility," Cole said. "Dealers seeking to plug the liquidity gap would then purchase S&P 500 options and forward variance swaps. In a hypothetical disaster scenario, the excess buying pressure exerted from the short-volatility complex spilling over to S&P 500 options may push spot-VIX higher contributing to panic selling in the underlying S&P 500 index and a vicious self-reinforcing cycle of fear followed by horror."
While many will debate the notion of volatility in the VIX itself feeding into the wider stock market, it is worth asking whether the increasingly erratic behavior of implied volatility could itself end up affecting the plethora of volatility-related products and trading strategies that have been built on it.
"VIX term structure inverted at the greatest degree in history in August, so much so and so fast that many structured products that use simple historical relationships to gauge term structure switching and hedging ratios just couldn't handle it," Cole told us.
He added: "With the growth of the short volatility complex, there has been a significant distortion, backed by moral hazard and embedded expectation of central bank support. If that support doesn't come through in the next volatility event, we could see an extreme reaction."