Authored by Christopher Cole via Artemis Capital Management,

Read Part 1: Fragility In The Market’s Medium, here…

“The post-modern volatility regime poses the question whether VIX ETNs and futures are large enough to influence the much deeper SPX options market. The existence of this dynamic would represent a self-reinforcing feedback loop with potentially dangerous repercussions.” -Artemis, “Volatility at Worlds End” March 2012 

“The wrong ‘risk-off’ event may expose a hidden liquidity gap in the short VIX complex that could unleash a monster.” – Artemis, “Volatility and Allegory of Prisoners Dilemma” October 2015 

“ The Global Short Volatility trade now represents an estimated $2+ trillion in financial engineering strategies that simultaneously exert influence over, and are influenced by, stock market volatility… Like a snake blind to the fact it is devouring its own body, the same factors that appear stabilizing can reverse into chaos.” – Artemis, “Volatility and the Alchemy of Risk, October 2017

Reflexivity in volatility has been a core focus of Artemis research for nearly a decade. The Artemis paper “Volatility at World’s End” published in 2012 contained the first of many warnings about the danger of VIX exchange traded products (see above).  More importantly, before they imploded, short-VIX ETPs ($3 billion) were the smallest constituent of the $2 trillion Global Short Volatility trade. The impact they had on global markets and market liquidity is just the canary in the coal mine.  

By now you know the story, a routine decline in equities caused a liquidity squeeze in retail-dominated short VIX products resulting in a self-reflexive spiral of buying pressure. At the end of the trading session, the VIX levered and short ETPs required more vega notional exposure than was available in the entire market, resulting in a feedback loop. The VIX registered the second largest draw up (+177%) and single largest drawdown (-43% over 5 days) in its 28-year history over a two-week span. During this wild round-trip to nowhere, the popular short VIX exchange traded products (“XIV”) were wiped out and many strategies that have consistently made money lost years of profits in an hour. 

The volatility spike in February is widely misunderstood… it was not a “volatility event” but instead a “liquidity crisis” resulting in rapid repricing of tail risk. Put simply, it was the moment where many ignorant market players learned what ‘water’ really is. During a true volatility event implied variance and demand for options increases across the board. Fixed strike and at-the-money volatility actually moved more in January (+3.5%) than it did in February (+3%). The early-February spike in VIX was driven by unprecedented demand for far out-of-the-money S&P 500 index puts, or tail options. Normally these options comprise about 10% of the VIX price, but in early February these tail risk options comprised upward of 35% of the VIX price.

Traders were not buying options because they thought volatility would increase, they were buying options because they were facing insolvency.  If you are a fish on dry land, how much will you pay for a glass of water?

Look, there has been so much talk about volatility and VIX exchange traded products lately… but that is yesterday’s news and is irrelevant.  Everyone is missing the forest from the trees… the pond from the ripples … In April, the commissioner of a major regulatory agency visited Artemis to discuss my research on short-volatility from last year. He asked whether I thought the VIX eco-system represented a systemic risk. I told him, “Forget VIX, that’s over. Done. But you should be VERY worried about how the bigger implicit short volatility trade affects liquidity in the overall market… THAT is the systemic risk.”

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