The CBOE Volatility Index (VIX) Complex Tinderbox

Recent action in CBOE Volatility Index (VIX) and its derivatives, like the iPath S&P 500 VIX Short-Term Futures ETN (VXX), show how far they've come

by Adam Warner

Published on Sep 1, 2015 at 9:30 AM
Updated on Sep 1, 2015 at 9:32 AM

What if we suddenly woke up in a world where the CBOE Volatility Index (VIX) stopped updating? We got a window into that Dystopian Hellscape during last week's implosion, as Bloomberg recounts:

"Among the many scary things traders witnessed as stocks plunged last Monday, one of the most harrowing was the sight of the VIX, an index designed to measure investor fear, briefly going dark.

For almost 30 minutes as hundreds of billions of dollars were erased from equities, no signals were sent by the world's most popular sentiment gauge as options prices turned erratic. When it switched on, the VIX jerked higher faster than anyone had ever seen, rising 82 percent on its first tick to 51, a level not reached since the financial crisis." 

It is kind of funny how we've come to hypothesize about the meaning of every VIX tick over the years (and yes, guilty as charged). It didn't exist in 1987, and no one really paid any attention to it until maybe 2002. Now it's gospel and it's traded via 500 different derivatives or so. 

Speaking of which, Bloomberg continues:

"Besides the VIX going dark, the most visible manifestation of the deluge was volume in futures tied to the VIX. In the hour before the market opened Monday, traders exchanged 78,000 of the September contracts, more than four times the average at that time in the 20 days prior, Bloomberg data show.

Traders were nervous, naturally. Some had to cover short positions in VIX futures, essentially bets on a rising stock market that had worked for years. Hedge-fund managers were net long more than 16,000 of these VIX contracts through Tuesday, as opposed to a net short 55,000 positions on Aug. 18, according to U.S. Commodity Futures Trading Commission data."

I don't believe VIX derivatives in any way caused the panic -- they're just not big enough. But I absolutely believe they added fuel to the fire between the price spike and the options volatility explosion. They're more dangerous than straight short puts in that they're open-ended and not backed by the fundamentals of an underlying company or index; it's based on a calculation, and that number knows few upward bounds. So the prospect of those sort of losses can certainly impact behavior, and not having an actual VIX to look at likely didn't help matters. 

The iPath S&P 500 VIX Short-Term Futures ETN (VXX) was the first VIX derivative exchange-traded note (ETN), and it's by far the biggest and most influential in the somewhat crowded space. And last Monday was indeed an extraordinary day, as it ran up $6.4 billion worth of dollar-weighted volume, an all-time record.

VXX dollar-weighted volume does trend up over time, very much exponentially from the early days. But even in that context, it was quite the spike. Here's a graph of dollar-weighted volume back to Day 1:

150901Warner

And yes, you'll need a magnifying glass to see anything before 2012, that's how popular VXX has become.

Here's a fun fact: VXX first listed on Jan. 30 2009; if you added up the dollar-weighted volume every trading session, it didn't surpass last Monday's dollar-weighted volume until May 16, 2011. In other words, the Aug. 24 session was as busy as the first 577 trading sessions combined. That's how fast this product has grown.

So, next time I make fun of VXX, remind me of this. And also remind me that this whole VIX complex is a bit of a tinderbox that can catch fire at a moment's notice. 

Disclaimer: Mr. Warner's opinions expressed above do not necessarily represent the views of Schaeffer's Investment Research.


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