So, everybody knows the VIX surged yesterday and is up massively over past sessions. CNBC, Bloomberg and other media are all busy commenting the VXI index having exploded to the upside. Very few of these pundits know how you calculate the index and even less what it prices. Simplified, current levels of VIX imply the market is pricing 1.5% daily moves in the SPX index.
More importantly than just pointing out the VIX spike, is the fact that over past months and in retrospect years, the volatility has decreased and investors have started using short vol strategies as “yield”.
Running short premium strategies has attracted many into what 99/100 times work, until it blows up. This is especially true in these days since very few managers have actually experienced sharp sell offs with vega and gamma risks exploding in their books.
Note the chart of VIX and the net non-commercial VIX futures. Unfortunately, the positioning chart hasn’t updated in the Bloomberg yet, but the positioning of investors coming into this event was extreme, i.e. many ran short VIX positions.
VIX orange, net non-commercial positions white. This explosion of VIX has killed many strategies in a few days.
Not only have people been “sucked” into short volatility strategies, many have also played the “vega neutral” strategies of selling front month vol hedged with long vol positions. This also works in a “normal” environment, but when positioning becomes extreme and when markets sell off fast, the entire curve explodes, leaving people with huge negative gamma positions that become very hard to manage. When things are calm these strategies are vega neutral, but when markets start rocking they become all but neutral. Very few know how to handle these types of risks.
The second chart shows the extreme shift in term structure of the SPX yesterday (orange today, blue 2 days ago, green 1 week ago). Short term maturities have absolutely exploded, both absolutely and relatively speaking. This has created huge derivatives risks that given the liquidity we have seen (and warned about a few weeks ago) has reinforced the move lower.
Where to next? We will leave that question to be answered by pundits, but all our macro cross asset risk indicators are much calmer than what the equity markets are showing. FX is calm, credit is relatively calm etc. Below is a chart showing iTraxx Europe versus Eurostoxx 50 (orange inverted). The big recent gap is basically telling us this is a very equity related sell off, and given the above regarding extreme positioning, don’t be surprised to see a bounce higher in equities.
Our reasoning of buying VIX as the best global hedge around on October 2nd has played out its logic and we would actually start thinking about the reverse position here. After all, “you shouldn’t buy vol when you must, you should buy it when you can”.
Source, charts by Bloomberg