It’s been a bit since we checked in on volatility in the market. In a nutshell, apart from the couple of day selloff in big tech names we saw last week, there hasn’t been much. This is becoming the norm and is something I’ve been arguing is the new norm for several reasons. To read more thoughts on that go here. In a nutshell I think that vol, both implied and realized has changed with algorithms and robo-advisors directing both passive equity investing (dampening realized vol, how much the market moves) and option positioning (more net sellers of options based on probability over human emotion). Of course, this observation has only been tested in a steady bull market, with the occasional flash crash. I just don’t know what happens when we see the next recession/ bear market.
One aspect to all this that I’ve only vaguely thought about is what effect the proliferation of vol ETNs (XIV, VXX etc.) are having on overall volatility. There was an interesting note featured in the WSJ’s Daily Shot yesterday. It quotes Stuart Barton from InvestinVol and his thoughts on what may be going on when dealers attempt to hedge the positions they’re taking on in these vol ETNs, and what could possibly happen when things change and the market has a legit sell-off. Let’s take this bit by bit and I’ll try the best I can to translate into plain English. Here is something fairly commonly known about these product and how people position:
With regard to the VIX ETPs that are out there at the moment, there seems to be a consensus that a great deal of the exposure is in the hands of end users – i.e. those investors who are taking a directional view rather than hedging themselves – is on the short volatility side.
This is something I’ve talked about, XIV is a great long term own with massive near term risk. VXX is a terrible long term own and not even a good short term own. Everyone knows that and therefore most flow in XIV is long, and most positioning in VXX is short. (Long XIV is short vol, short VXX is short vol) Still with me? Ok, the next part:
If the investing public is in fact net short a great deal of this, the dealers are left net long – like Barclays who may create units of VXX in order to lend out and capture the borrow cost which can equate to several percent a year. This resulting long net ETP position can be hedged fully with VIX futures, but as futures are just contracts-for-difference, any hedge just moves the exposure from one trader’s book to another. The best proxy hedge is to trade short-dated S&P 500 options that can offer a highly correlated hedge to the ETPs and futures.
What he’s saying here is that the investing public is shorting a great deal of volatility as an asset, either by shorting long vol ETNs or buying short vol ETNs. The institutions on the other side are then hedging that risk of being net long vol through these ETFs by turning around and selling vol via S&P 500 options:
But here is where the rubber meets the road; delta-hedged S&P options that are used to hedge volatility products have gamma on them – i.e. their exposure to the value of the S&P changes as the level of the S&P 500 moves.
And therefore we have an imbalance if the market were to see volatility, as selling options in the S&P 500 as a hedge means there’s stock to sell (when the market goes lower) or buy (when the market goes higher) but there’s no corresponding long gamma on the vol ETN side to in anyway balance it out.
this proxy hedge could have some interesting effects on the S&P when volatility starts to rise. For one, if the S&P market started to fall, dealers would become longer and longer S&P 500 delta (stock exposure), effectively making their losses exponential as the market falls. Of course, dealers would sell some of this exposure in a falling market, but this might in itself accelerate an already weakening market.
I’m not sure exactly what to make of it. And again we’ve seen such low volatility recently that it feels like all of these factors are compounding on the side of too much gamma in the market (buyers of stocks appear when the market goes down, sellers appear when it goes up). But maybe that’s simply something that feels like gamma, and in fact it’s just the algos stepping in at tight technical ranges and not panicking either way, having nothing to do with gamma.
But to Stuart’s overall point, there’s still so much mystery of what this market looks like if we ever do see people returning to sell stocks en masse under these new circumstances. Everyone says it’s “never different this time”. But think about what actually is different in this market since the last time we saw a protracted sell-off. We have exponentially increased passive investing, we have seen roboadvisors and trading algos proliferate, retail has become a net seller of vol through ETNs. The kicker is we’ve run this test in an extremely low volatility bull market for the past few years without a test case on the other side. My bet is we remain in “the new normal” for long periods of time with selloffs that are immediately bought as “the damn dip” and a continuation of the assumption that vol is over priced. But the thing is, I have no idea what things look like vol wise when the Bull market ends and robo selling of stocks becomes as consistent as the robo buying has been. We’ll eventually find out.