On Feb. 7 Cboe Global Markets held a teleconference after the market close “to provide an overview of recent market conditions and address certain concerns around market volatility and the Cboe Volatility Index (VIX Index).”
Cboe Chairman and CEO Ed Tilly sounded a bit perplexed when explaining what happened on the call following the massive market sell-off. Perhaps he sounded perplexed because the VIX acted as one would expect in such a move. “A sudden and steep decline, such as the one that we experienced on Monday, will be punctuated with a sharp increase in the market volatility,” Tilly said. “However, VIX and VIX related [exchange traded products] continued to work as designed. Strategies and funds that incorporated volatility protection generally benefit while funds and strategies designed to short volatility suffered.”
However, many analysts were looking to place blame for the carnage—as if blame needed to be placed for a much overdue market correction. And as often is the case in the financial media, they looked to the world of derivatives. Analysts were focusing on the XIV, and other inverse and leveraged exchange traded notes tied to the Cboe Volatility Index (VIX).
The XIV tanked as one would expect under these circumstances. The Wall Street Journal reported “Credit Suisse Group AG announced an event acceleration of its VelocityShares Daily Inverse VIX Short Term Exchange-Traded Note, effectively announcing the liquidation of a product that allows investors to bet on muted moves in the stock market.”
This product and products like them account for volume in VIX futures and options, but not so much to justify the sharp, 17%, sell-off in Cboe stock that followed. It may have been due to Goldman Sachs and JP Morgan changing their outlook on Cboe stock from buy to neutral due to risks associated with short-VIX strategies.
In fact, it seems logical that much of the volume created by traders accessing short volatility ETPs comes from people who otherwise might have been using more traditional VIX products. Though, now that volatility has come off of the floor, it would make more sense to short volatility than when it was wallowing at historic lows.
A little over six months ago in our October options issue, we reported on the trend of shorting volatility. It had been a successful strategy but seemed a bit overdone and extremely dangerous in a period of historically low volatility.
Warrington Asset Management founder Scott Kimple provided a warning regarding this trend. He noted that central bank activity had kept market volatility low as the very low interest rates forced people into risk assets. “The big story is this untried untested central bank activity has caused volatility to be abnormally low. It has caused an interest in the space, especially in short volatility,” Kimple says. “The only way to make money the last couple of years has been in the short volatility space. It has caused a dramatic increase in structured products related to getting short volatility.”
He referred to traders accessing these inverse VIX products as “volatility tourists,” and added that it was extremely risky.
He pointed out that most of the traders and managers accessing these products have only been trading this strategy since 2012 and later, so that it has not ever been tested during a major volatility spike. He added that since volatility has continued to shrink— noting that at the time the VIX had settled 26 times below ’10, and 17 of those occasions occurred in 2017— traders short volatility had to increase their risk to maintain returns. “The only way they have been able to do that is by ramping up their risk and when — not if — volatility increases; these are going to be the guys taken out on a stretcher. That is always the case.”
Of course, Kimple was right. But the problem wasn’t due to a product that allows investors to short volatility, it was due to an age old problem of certain investors believing that “this time was different.”
While the strategy had worked, as volatility continued to shrink, it became more and more risky. Any value trader would tell you that it does not make a lot of sense to short a market at historic lows, even if your outlook is still bearish.
The reaction in the stock price of Cboe further deteriorated after it revealed a fourth quarter earnings miss of 1¢ today. The additional 12% decline seemed extreme for a one penny miss and may be more attributable to the weakness due to the XIV failure. And like the broader market itself, Cboe stock—which has been on impressive and virtually unimpeded move higher for two years—was due a correction. Still it seems odd that Cboe would suffer from a market correction based on an underlying product created to help traders mitigate risk in case of market volatility. Yes, products created to short volatility has helped increase volume on Cboe products, but if we are entering a period with a more balanced level of volatility, it shouldn’t harm overall volume in VIX.