Something wicked this way comes.
February 5th of this year was a miserable day for some. Anyone long the XIV (otherwise known as the VelocityShares Daily Inverse VIX Short Term ETN) would have had the unpleasant experience of watching their capital evaporate following a spectacular after-hours selloff.
The XIV – its name now a memento mori of the former exchange traded fund – was a way to bet on low market volatility. Investors could buy stock with the ticker XIV (in the same way they could buy Boeing stock or Apple stock) but rather than making planes or selling iPhones, the XIV was solely in the business of selling futures against a volatility index – everyone has to make a living, right? The volatility index in this instance is the CBOE Volatility Index, a.k.a. the VIX.
Popular trades beget further popularity. During the volatility doldrums of 2017 (some of the lowest volatility in decades), more and more capital flowed into the XIV and investors made huge gains. But the strategy is very dangerous. As volatility rises, the XIV has to purchase more and more futures to bet against even further rises – this pro-cyclical nature led to a situation where in the space of just 15 minutes, the XIV tried to force through a number of futures trades (unsuccessfully) and the product ultimately went to near zero.
While the XIV example is only a fraction of the total market (it wiped $3 billion of value, but the US market is something in the order of $30 trillion) it is also the most visible. Less visible are the host of subcutaneous capital pools out there that take volatility as an input to the sizing of their funds, so when volatility goes up they are required to sell. Products like risk parity, CTA trend following, vol-controlled funds, etc. – no-one really knows how big these pools of funds are, but they must be substantial. For instance, last month there was a jump in daily volatility that was 10x the normal levels (400bps vs a typical 40bps) – a de-risking caused by a spike in volatility, and volatility drove further derisking, feeding back into the system in a Minsky style moment.
Right now, nothing is more reflexive than the coiled spring of volatility.
