In this article, we analyse the disastrous ‘short vol’ trade that wiped out a lot of traders last week and draw some lessons learned from it.
The VIX is the Chicago Board Options Exchange Volatility Index. It shows the expected 30-day volatility of the S&P 500 by calculating the implied volatilities on options relating to the index. It is often known as the ‘fear gauge’, which is particularly appropriate since stock market options are typically used for hedging, meaning there are more ‘put’ options (that protect against market declines). This means the VIX is predominantly based on protection against negative market movements rather than positive ones.
The VIX is an index rather than an asset, so it is not directly tradeable. Instead, if people want to trade based on it they need to use derivatives and other products that are linked to the index. This is what we have seen taking place over the last few years, with people shorting the VIX (making money from it going down). This is also known as going short volatility, or short vol.
The chart above shows that volatility was dropping. It was one of the best trades in 2017 and a lot of people jumped on board, despite warnings from analysts from the middle of 2017 onwards that this was becoming a crowded trade.
How to short vol
Trading volatility will involve using derivatives or other similar products. This typically means the product will be complex in nature and very risky. Barron’s explains one of the approaches quite nicely and succinctly in a paragraph:
“VIX futures traded above the level of the “spot” VIX quoted in the media–the so-called fear gauge–a condition called “contango” in the futures market. As the VIX futures approach expiration, their prices converge on the spot VIX, falling from 3% to 10% per month. The VIX futures short-sellers then get to cover at a profit–if markets maintain their historically low volatility; that is, if nothing bad happens. As the stock market continued on its straight-line ascent, the record-low VIX made the strategy a sure thing.”
A more straight-forward explanation is to buy an ETN, which stands for Exchange Traded Note. Amongst the most popular of these was the XIV; the VelocityShares Daily Inverse VIX. This is an inverse of the VIX, meaning when the VIX is going down, this is going up.
It is important to note that this is not an ETF (an exchange traded fund). There are no assets in an ETN, it is actually a debt note. In this case, it was Credit Suisse issuing the debt and the note is tracked against the VIX. This is a bit complicated to go through in detail for this article (and we do not think it is particularly necessary), but it is important to understand how risky these ETNs can be. They are actually designed to be a ticking time bomb, so trading them can be like a game of hot potato; it is ok to hold it and pass it on, but you do not want to be the one left holding it when the time runs out.
In fact, Credit Suisse even mentioned in their prospectus that “In almost any potential scenario the Closing Indicative Value of your ETNs is likely to be close to zero after 20 years and we do not intend or expect any investor to hold the ETNs from inception to maturity“.
In simple terms, this means that Credit Suisse expects you to lose all your money if you buy an ETN and hold it over the long term. That makes it an extremely risky product by nature.
Yet people kept jumping into this short vol trade, as it seemed as though it was something relatively guaranteed and low risk. Stocks had not dropped more than 5% for over 400 days, people got complacent and believed this was just how the markets were going to be from now on. Short vol was a money printing machine.
However, the trade getting more popular also led to it becoming somewhat overcrowded and this is what eventually caused its demise.
If a product is expected by its issuer to make you lose your money over the long term, then it is no surprise if it blows up eventually. But the way this situation happened, may be seen by some as a form of black swan event.
As these derivative products became more popular (with the XIV being valued the week before the crash at about $2 billion) the risk they carried increased as well. This led to volatility creating more volatility, as vol short-sellers had to cover their losses, creating a liquidation event. This made the VIX spike beyond what would have been expected even during major historic crashes of the past. This all took place on a day when there was no significant bad news. There was no ‘too big to fail’ bank collapsing or government defaulting. It was just expectations of interest rate rises and rising yields, as a result of a strengthening economy.
Analysts have uncovered that the erratic volatility spike may have also deepened the crash in the US stock market, therefore it may not have just been the fundamental factors causing selling in the market, but also this liquidation event caused by complacent traders. However, worryingly there is still an estimated $100 billion of exposure for short vol trades that will need to be liquidated soon if volatility continues to be elevated. The potential negative effect of this is definitely a concern.
In terms of the liquidity event from last week, Credit Suisse will be in the line of fire as the issuer of the ETN. They put out a one-sentence statement claiming they did not lose any money as a result of this, which means they must have been hedging their exposure. However, if this goes further in terms of regulators or a legal route due to the riskiness of the product and how it was explained to clients, Credit Suisse may still be exposed.
Overall, the lesson we can learn here is that no trade is ever a ‘sure thing’ and we should always think of the extreme downside when monitoring our risk. Putting all your funds in something, no matter how guaranteed it might seem to be, is just asking for trouble. If the opportunity is that great and everybody is talking about it, this creates severe risks of its own.
The definition of a black swan event may conclude that the event is unlikely to happen, but it has now been proven that these ‘tail risks’ occur more often than we expect. Therefore, we should not discount them entirely from our assessments.
In conclusion, we would like to quote Jim Collins (writing for Forbes) to sum it all up:
“The worst part of my job as a financial pundit is having to listen to pinheaded quasi-professional investors who believe they have gamed the system via derivative securities so that they can make money in any market condition. We market veterans know that “it always works” is really just shorthand for “it works until it doesn’t work.”