Research - Anti-Volatility ImplosionResearch - Anti-Volatility Implosion
The primary takeaway from this article is that markets can be wrong for a long while before price reacts. In such cases, price and sentiment often take a sharp swing in the opposite direction as the market collectively gets shaken out of false narratives. This has happened several times in the past, with the most recent example being Netflix.
Let’s explore one such example in recent history when a $2 billion market cap asset fell to zero in just a few days.
This is Credit Suisse’s ill-fated exchange traded product called XIV. Its price rose spectacularly in the couple years leading up to early February 2018 when it proceeded to lose most of its value in just a few days and was finally liquidated.
One of the scariest things about XIV’s demise is that most of its value ($100 → $20) was lost in one after-hours trading session. It was only down 14% during regular trading hours on the same day! Imagine being invested in XIV and seeing 80% of your position evaporate in the evening when you can’t do anything about it.
Let’s break down what happened to the XIV and, in the process, learn about volatility, the VIX, and draw lessons from this debacle.
The Rise of Volatility Trading
Volatility is, put simply, a measure of how much a stock’s price moves in a period of time. If price swings wildly or rises/falls dramatically, volatility is up. If price is barely moving, volatility is down.
Volatility has only relatively recently (last two decades-ish) been a popular topic on Wall Street. While volatility has always been a fundamental aspect of stock markets, it only became tradeable as an asset class after the launch of futures and options for the vaunted volatility index VIX in the mid-2000s.
And Wall Street loved trading volatility. By the mid-2010s, the best and brightest talent on Wall Street were all seemingly involved with it.
Two primary trading strategies emerged:
- Short volatility: a strategy that constantly shorted volatility to earn a stable income stream. This strategy worked as long as nothing crazy happened in the markets. The 2010s was a relatively calm decade, perfect for this strategy.
- Long volatility: a strategy that uses volatility as a hedge against the stock market. Traders noticed that volatility tended to spike when the stock market fell. This inverse correlation during times of market stress made volatility a great way to diversify a portfolio. This was further solidified during the COVID downturn when bonds and stocks fell together while volatility went up.
Tangent: What is the VIX?
No discussion of volatility is complete without mentioning the VIX (CBOE Volatility Index). Since its creation in 1993, the VIX has solidified itself as the top measure of expected stock market volatility. These days, the VIX is synonymous with volatility and it’s almost impossible to not hear about the VIX whenever volatility comes up. With the volatile markets of late, the VIX seems to be all over the financial airwaves.
So what is the VIX exactly and how is it calculated?
The VIX is calculated using the prices of put and call out-of-the-money options for the S&P 500 index. The general idea is that the higher the prices for these options, the more the market expects an upcoming volatile move for the S&P 500 will happen. In addition, recent volatility also increases options prices.
I have to give kudos to the designers of the VIX. Using the prices of out-of-the-money options as a proxy for expected volatility is ingenious. In a volatile environment, traders will pay more for out-of-the-money options since it’s more likely for a stock’s price to get to and surpass the option’s strike price (which increases its value dramatically). On the flip-side, if the S&P 500 is moving slowly and people don’t expect impending volatile moves, traders will pay a lower price for out-of-the-money options
To summarize this tangent, the VIX’s clever use of the prices of out-of-the-money options makes it a very effective proxy for expected volatility. No wonder the VIX has become synonymous with volatility.
An Infinite Supply of Free Lunches
An interesting phenomenon, that of dramatically low volatility, started to emerge at the start of the prior decade as we emerged from the Great Financial Crisis. The likely causes of this are the rise of passive investing, the Federal Reserve’s copious use of quantitative easing to support the economy, and a negative feedback loop from volatility selling.
This drop in volatility made the anti-volatility trade increasingly popular throughout the decade. Many funds sprung up that systematically sold volatility to earn a steady flow of market-beating income. This worked, as long as nothing crazy happened in the market, and it was an unusually peaceful market from 2010 to 2018.
Naturally, the more this anti-volatility trade worked, the more people piled on to it. In addition, selling volatility had a self-reinforcing effect of reducing volatility further. This meant that the more people bought in to the anti-volatility trade, the better it appeared to be working. Volatility was getting compressed like a spring and it was ready to burst with a vengeance given any disturbance.
Enter XIV and SVXY
One of the most popular ways for retail traders to take part in the anti-volatility trade was to buy short volatility exchange traded products (ETPs) like XIV and SVXY.
Since the VIX is an index (i.e. a calculation), it wasn’t something you could buy or sell directly. This didn’t stop people from trying and several ETPs were invented that tried to track the VIX as best as they could. The primary way these ETPs did so was through the VIX futures market. For ETPs that wanted to track the VIX, they would buy VIX futures contracts with further out expiration dates (i.e. long-dated contracts), held them until they were close to expiration, sell them, then buy more long-dated contracts.
Although this methodology tracked the VIX adequately in the short-term, it would almost always lose money in the long-term, since the VIX futures market was in contango for much of the 2010s. That is to say, the further out a futures contract expired, the more expensive it would be (traders expected more volatility in the future).
As such, these VIX ETPs would constantly be buying long-dated contracts, holding them till they were close to expiry, and selling them at a loss.
If the ETPs that tracked the VIX were constantly losing money, people soon cleverly realized that it’d be much better to do the opposite. That’s how the XIV and SVXY worked, and why they became immensely popular leading up to February 2018.
Both of these inverse VIX ETPs would short long-dated VIX futures contracts and buy them back at a discount when expiration neared. This was effectively shorting volatility and the method worked incredibly well for a time. As long as the VIX futures market was in contango, XIV and SVXY would make money. It felt like a free lunch. Actually, it was more like an infinite supply of free lunches.
It’s no wonder traders piled on to both XIV and SVXY, thus skyrocketing their prices.
The anti-volatility trade felt so right, almost euphoric, up until the moment it stopped working when volatility spiked and the VIX more than doubled in one day on February 5th, 2018. The S&P 500 only fell about 5% that day, yet the VIX went from 19 at open to over 38. This intra-day jump was proportionally larger than even its largest intra-day jump of +70% during the Great Financial Crisis.
The coiled volatility spring unleashed all of its pent-up energy on the crowd of complacent traders piled on top of it.
Surprisingly, XIV was only down 14% during regular trading hours on this day but this was just setting the stage for a bloodbath in after-hours. 80% of XIV’s value was wiped out overnight. Most retail traders didn’t have access to after-hours trading and one can only imagine the helpless panic that ensued.
This after-hours carnage was caused by a massive short squeeze on the inverse VIX ETPs brought forth by the VIX’s huge intra-day jump, resulting in margin calls that forced the ETPs to unravel their VIX futures short positions. This unsurprisingly imploded their valuations and eventually led to Credit Suisse terminating the XIV.
Let’s circle back to the primary takeaway of this article that I mentioned at the very start. This anti-volatility implosion debacle is a great example of how markets can be very wrong for a long time before catalysts shake the market collectively out of false narratives, resulting in violent price reversals.
In today’s social media-driven, momentum-filled stock market, these situations happen frequently. Some examples include:
- Tesla in 2019 when it proved that it wasn’t going insolvent and could successfully mass produce the Model 3.
- the COVID downturn when “Wuhan” Google searches peaked in January, yet the market kept climbing until February 20th when the panic selling began.
- Netflix where positive sentiment for the company was so sticky despite the launch of a myriad of competitors over the last couple years, each with their own line-up of hit shows. All it took was one disastrous quarterly earnings report for the narrative to immediately and completely change.
As such, the New Age Investor looking to significantly outperform the market, or avoid dangerous risks, mustn’t be too complacent and settle with the crowd. Price action can always greatly decouple from reality and shouldn’t entirely define your sentiment and understanding of an investment idea.
To put it in a more positive note, the market’s collective misunderstanding of a situation presents massive opportunities that can last for a long time before catalysts dispel false narratives. It’s the job of the New Age Investor to actively hunt for these opportunities.