VIX: From Insurance to Assurance
Heading into next week's highly anticipated Fed decision and assessing the prospects for further market volatility, we take a look at futures' traders commitments in the Chicago Board Options Exchange Volatility Index, which have reached record high in the week ending Tuesday. How can a record surge occur when risks are nowhere near those in 2008, 2000 or 1998?
The latest data showed long contracts in the VIX exceeded shorts by a net positive 32,239 contracts, exceeding previous record in February. Notably, positioning went from a net short of 54,894 contracts to a net long balance of 32,239 in a matter of two weeks.
Events such as the biggest daily point drop in the Dow on August 24 and the largest percentage decline in most indices since 2008, prompted by worries of a China hard landing are all directly related to the surge in the VIX.
More Record Volatility ahead
Yet, in order for the VIX and net positioning to surpass the levels of 1998, 2008 or 2011 -- all years highlighted by events more threatening to the financial system than today, the only reason must be innovation and technology.
Volatility has evolved to becoming an asset class, exploited by quantitative trading strategies aimed at extracting profits from falling and rising volatility. A plethora of VIX derivatives (options and futures) and exchange-traded products are being used by fund managers in New York or retail investors in New Delhi.
A principal reason that August 24 saw an unprecedented 91% jump in the VIX was a scramble by volatility traders rushing to buy VIX contracts -- either in the form of seeking protection against a falling market or hedging to cover short positions, initiated during "low risk" climate. Both operations amplified volatility significantly.
On the retail space, one major culprit to the VIX's violent surge has been exchange-traded notes and funds, such as the iPath S&P 500 VIX Short-Term Futures ETN, which heavily trade VIX futures in order to replicate it for hedge funds and retail investors.
As in the 1987 crash, the combination of high frequency traders and multiple derivative products aimed at betting against and on volatility -- will risk transforming volatility insurance into volatility assurance.
Next week's Fed decision will magnify volatility regardless of the outcome. A Fed hike would intensify fears of global deflationary spiral from a strong dollar and Chinese hard landing. Doing nothing will keep the threat of such a hike ongoing into each subsequent meeting. If you think the record high in VIX net longs is a contrary indicator, think again.