Market Dynamics 101: Even VIX Finds Equilibrium

Is it time to preemptively blame VIX products for the next market ugliness?

Oct 16, 2015 at 9:19 AM
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The Tradeable VIX Complex continues to grow and grow. Each time we get a CBOE Volatility Index (VIX) pop, there are more products to trade -- and more liquidity in those products. Our newest addition(s)? Weekly VIX futures and options.

So, is it time to preemptively blame the popularity of All Things VIX for the next market ugliness? This, from Bloomberg:

"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."

OK, it's not that much of an unknown. We literally saw this happen in late August. VIX lifted at record speed, and it's safe to say a lot of that had to do with trapped volatility shorts covering their positions. It was a classic short vol. squeeze, something we've seen at times since the invention of the put option. The dynamics didn't change, just the vehicles to trade.

Easy Central Bank Money is always a convenient scapegoat, but I don't believe you really need a proximal "cause" here. That's not what causes traders of various sizes and stripes to go short volatility. Quite simply, it's the fact that volatility overprices the actual risks. We've mentioned that in this space about 1,000 times.

Here's a quick refresher: Implied volatility trades at a premium to realized volatility -- typically about a 4-volatility-point premium. VIX futures virtually always trade in contango, meaning the futures themselves trade at ever higher levels the further you go out in time. They almost all trade at a premium to VIX itself.

It all works splendidly… until there is a sizable move in the wrong direction.

All markets ultimately find an equilibrium, and this one does too. If shorting vol. becomes too popular, prices will drop. And if prices drop too far, shorting vol. won't work anymore. You can make a case that's happened over the past year or two. The trade maybe got too crowded, traders got burned badly in August, rinse, repeat. And over time that will have the effect of rising prices. And so on.

My point is, this is all Market Dynamics 101. VIX shorting is essentially open ended, so yes, it can cause a cascade. So is put selling, and that market is still way larger than the vol. market. You'll get some shakeouts, but prices will simply rise over time until we get away from equilibrium the other way. Same as it ever was. There's nothing about VIX trading that's at all likely to cause any extra pain.

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


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