Wednesday, February 14, 2018

The volatility trade casino

Ananth points to two links that highlights the casino that implied volatility trading has become. 

The market for exchange traded products (ETPs) in equity implied volatility, VIX futures, has exploded spectacularly with handsome returns since the turn of the decade. In the turmoil early last week, short positions which had been built up in the confidence complacency arising from the recent period of extraordinary stability in VIX, despite several signatures of bubbles, unravelled over just a few hours. Sample this
The scale of the returns the trade offered dulled the risks. Buying the largest short volatility ETP — run by Credit Suisse and known by the ticker XIV — at the start of 2015 and holding it to the end of 2017 generated a return of 320 per cent. Holding it from the start of 2015 to after Monday’s eruption, resulted in a total loss of 85 per cent... There are about 40 Vix-linked ETPs, according to Goldman Sachs, and most allow investors to bet on volatility rising... many have become popular, ranking among the most frequently traded exchange products, and rivalling the stocks of companies such as General Electric. 
And the systemic consequences have been, like with commodity futures, less than benign, with futures trading fuelling feedback loops into VIX itself,
“Volatility has become both an input for risk-taking, and something you can trade,” says Christopher Cole of Artemis Capital Management. “Volatility has become a player on the field.” In turn, the behaviour of the ETPs has helped fuel the Vix contracts that form their basis. So much so that it has led to concern that the financial products built to make money from tracking the Vix are now feeding back into the ingredients from which Vix is calculated. Traders say that at the end of Monday, the ETPs that ran into trouble from an initial rise in Vix scrambled to cover positions by buying large amounts of Vix futures, sending the price of the contracts soaring. The Vix, in turn, rose further and the S&P 500 sank.
And how did the markets respond to the unravelling of short positions - by swinging to the other extreme with the biggest ever weekly change into long-positions and the highest level of net long positions as a share of open interest in VIX futures since December 2009! 

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