In the past few days, investors have seen something that they havent been accustomed to in a while; a broad market slump. It began on Friday, but the selling pressure picked up steam on Monday (February 5th) as theS&P 500 Indexclosed down 4.10% for the day.
After the close, futures continued to fall into the following Asian trading day, extending the sell-off to 8%. However, from around midnight Eastern onwards in Tuesday, futures recovered to post a 5.40% loss on the session. TheNikkei 225closed down 4.73%,Eurostoxx 50was down 2.41%, theFTSEwas down 2.64% and U.S. Futures were down 1.3% in the full Tuesday session.
(Source: Bloomberg, as of 2/6/18)
But while these numbers served as a rude awakening to many investors, the real focus was arguably the incredible spike involatility.
Fear Index In Focus
VIX, a measure of volatility or risk, jumped to 37.32 from 17.31 on Monday, one of the largest moves ever. This was the highest closing volatility since August 2015, and the volatility spike is possibly the key to this story and will no doubt be an important topic of discussion for investors in the future (Source: Bloomberg, as of 2/6/18).
But whats behind this huge increase in volatility and why is it such an in-focus topic right now?
Most generally understand that equity price movements and volatility are connected and a down market means an increase in volatility. We also generally believe the stock market is what drives volatility. However, it appears in this case, volatility itself has driven the market lower.
This recent market move was a trading event and not based on fundamentals. This is partially due to how volatility-linked products are constructed and the nature of thederivativemarket. In short, in any chain of derivatives (things that derive their price from other assets), a market in one has the potential to affect the other. There are going to be a lot of stories on this subject over the coming days, but here is what you need to know to understand it.
What Happened?
On February 5th(Monday), the buying of volatility caused the market to move lower. This can happen when people who were long stocks and were concerned about a draw down act to purchase insurance in the form of options. Investors of all types bought this protection, and as such, there was a natural premium to be made by the parties willing to insure portfolios and take on the risk, the option sellers. This makes sense.
However, over the past few years markets have not been very risky. People often still buy insurance, but the outlook of low risk has led to more people being willing to play the role of insurer. Whats interesting is that when the number of people willing to be the insurance company-in other words, sell volatility– grows they actually begin to depress volatility itself. This happens a) because there is increasing supply from sellers and b) because the liquidity providers have become larger buyers of volatility in the recent year, their hedging activities lead to buying of more stocks. This pushes the price of the underlying market higher and therefore makes the market historically less volatile. The cycle then repeats with more and more participants willing to be sellers.
The (partial) unwind of this trade is what happened in recent action. For the first month of the year, stocks moved steeply higher leading to a couple of things. Volatility crept higher to the upside which started to worryshortsellers of volatility. But more importantly perhaps, investors started to become increasingly concerned that the market was due for a sell-off. All we needed was a catalyst to tip the balance. Fear of rising rates may have been that catalyst.
Once some participants started to trim positions in stocks, take off short volatility positions (which leads to downstream selling of stock) or begin buying protection (also leading to downstream selling of stock) the market will begin to fall. This was exacerbated by risk parity funds having to reduce equity positions due to the relatively large move in rates. This in turn caused volatility to rise. VIX moved from around 11 to 17 by the end of the volatile week (source: As of Date). The stage was set.
On Monday, sellers of volatility were experiencing losses as VIX rose and received margin calls on their positions. These participants, institutions and retail accounts alike, began to unwind there short VIX or volatility positions. Every buy of VIX leads to a sell of S&P 500 stocks.
The cycle I described earlier rapidly begins to unwind. Volatility goes up, people cover shorts or buy protection, volatility goes higher, people need to cover more shorts or want to buy more protection. Around this time, people also start to sell stock in the traditional sense which compounds the issue. VIX closed at 37! In Tuesday trading, VIX topped 50 before moving back into the 37 area (Source: Bloomberg, as of 2/6/18). This is unprecedented.
Long-Term Effects?
The good news is that volatility spikes tend to be short term and much of the pain is cleared in the first day or two of the move. Research suggests that hedge funds have become the largest holders of short volatility positions. However, the short volatilityETF/ETNshave captured attention as they are fully transparent so their trading is easy to track.
According to UBS, as volatility moved higher, these strategies had to buy an estimated $250mm of Vega (volatility risk) which equates to roughly selling of $16bn in the underlying S&P 500. Given the total average daily volume on all US exchanges of $280bn and, for some context, the largest S&P 500 ETFs average volume of $18.5bn, this is a significant trade. These rebalancing trades also tend to accelerate into the close. I should add that the ETFs and ETNs are simply vehicles for expressing these long and short views.
Other participants, and apparently the largest group of participants, express these short volatility positions with options and futures (on the S&P 500 and/or VIX) directly. So with the much broader buying back or buying long of volatility currently its no surprise we saw downward pressure on the S&P500.
In summary, sellers of volatility can make hedging portfolio risk cheaper for investors. This is a good thing. They also make markets less volatile, albeit potentially artificially. The challenge with suppressed volatility is that it has the propensity to unwind quickly as we saw recently. This is a fascinating market and Ill be keeping a close eye on it. It will be interesting to see where volatility will normalize.
Luke Oliver is the Head of U.S. ETF Capital Markets for Deutsche Xtrackers
