In recent years, strategies selling volatility (and VIX® futures in particular) garnered substantial attention due to the low levels of VIX and the eye-watering returns achieved by associated benchmarks such as the S&P 500® VIX Short-Term Futures Inverse Daily Index (we’ll call it the “short VIX index” here for convenience). At the end of last week, the short VIX index could boast of a 10-year total return of 1,518%.
We’ve previously warned that short VIX strategies should be exclusive to the courageous, especially in times of low volatility. The past 24 hours remind us why this must be so: by the end of Monday’s trading, as both VIX and VIX futures recorded their largest ever one-day percentage increases, the 10-year total return of the short VIX index had fallen from a 15-multiple gain, to a loss of 3.6%.
So, what just happened?
One candidate explanation for the remarkable swings in VIX futures yesterday relates to a phenomenon similar in spirit to a combination of a classic “short squeeze” with the types of trading patterns generated by portfolio insurance strategies. It is best illustrated by the hypothetical example of an investor following a strategy selling VIX futures in equal proportion to their invested capital.
Let’s suppose that – at the market’s open on Monday morning – an investor had a collateralized position in futures (or other index-linked products) tracking the short VIX index, with a notional position size of $100.
By the end of the Monday’s trading, as VIX futures rose by a total 96%, the value of the futures which our investor was short rose from $100 to $196. The $96 increase in the VIX futures position necessitates an equal and opposite decline in the value of our investor’s position: from $100 down to $4.
In order to maintain his short position at a fixed proportion of capital, the investor would have to reduce the size of his exposure from $196 to $4; in other words to purchase $192 of VIX futures. This adjustment would naturally have had the effect of putting further upward pressure on VIX levels.
It is not clear how many investors were following such a strategy overall, but a lower bound might be approximated by the $3bn of assets in ETPs (exchange-traded notes and exchange-traded funds) that were tracking the short VIX index as of Friday’s close. From that approximation, we would have anticipated a little under $6bn of “short covering” in VIX futures into yesterday’s close – an amount that may have indeed exacerbated the market’s moves.
And is it over yet?
There are plenty of other candidate explanations for the market’s movements yesterday. However, if the primary driver was indeed the rebalancing flows (and short-covering) from investors who were short volatility, the good news is that it’s quite possible the market will return to normal. The same $3bn of assets tracking short volatility at Friday’s close would be worth only $0.12bn after yesterday’s losses, which is far less likely to move the market. Of course, if the real reason for the market moves lay elsewhere, higher volatility may well continue. At any rate, we suspect that after such a lesson in the possibility of sharp spikes in the volatility market, investors will approach short VIX strategies with renewed caution.