AI
Wednesday, October 14, 2015 1:42:23 PM
$VIX... "Black Swan"
http://www.bloomberg.com/news/articles/2015-10-14/volatility-traders-have-a-big-problem-themselves
The returns on offer from selling volatility have lured a host of participants to the strategy, with everyone from large asset managers to retail investors using a variety of volatility-related structured products to short-sell VIX futures alongside more traditional "vol sellers," such as banks and hedge funds.
But as the punch bowl of the central bank put is taken away, the chances of the strategy going awry increase, a risk heightened by the preponderance of volatility sellers who have been shorting the VIX. And while Cole talks of "unknowable consequences," he has a particular "black swan" scenario in mind.
He foresees a sudden market event that forces the VIX up sharply, causing a wave of hedging by traditional volatility-sellers who—thanks to structural quirks in the way they trade—are then forced to buy VIX futures. That could spur volatility sellers to buy a bevy of alternative financial instruments as they desperately seek to rebalance their portfolios.
"The VIX futures market may struggle to absorb the demand for long volatility and dealers would be forced to rely on other sources for forward volatility," Cole says. "Dealers seeking to plug the liquidity gap would then purchase S&P 500 options and forward variance swaps. In a hypothetical disaster scenario, the excess buying pressure exerted from the short-volatility complex spilling over to S&P 500 options may push spot-VIX higher contributing to panic selling in the underlying S&P 500 index and a vicious self-reinforcing cycle of fear followed by horror."
While many will debate the notion of volatility in the VIX itself feeding into the wider stock market, it's certainly worth asking whether the increasingly erratic behavior of implied volatility itself could end up biting the plethora of volatility-related products and trading strategies now built on top of it.
"VIX term structure inverted at the greatest degree in history in August, so much so and so fast that many structured products that use simple historical relationships to gauge term structure switching and hedging ratios just couldn't handle it," Cole said in an interview.
He added: "With the growth of the short volatility complex there has been a significant distortion backed by moral hazard and embedded expectation of central bank support. If that support doesn't come through in the next volatility event, we could see an extreme reaction."
Daily
$VIX... "Black Swan"
http://www.bloomberg.com/news/articles/2015-10-14/volatility-traders-have-a-big-problem-themselves
The returns on offer from selling volatility have lured a host of participants to the strategy, with everyone from large asset managers to retail investors using a variety of volatility-related structured products to short-sell VIX futures alongside more traditional "vol sellers," such as banks and hedge funds.
But as the punch bowl of the central bank put is taken away, the chances of the strategy going awry increase, a risk heightened by the preponderance of volatility sellers who have been shorting the VIX. And while Cole talks of "unknowable consequences," he has a particular "black swan" scenario in mind.
He foresees a sudden market event that forces the VIX up sharply, causing a wave of hedging by traditional volatility-sellers who—thanks to structural quirks in the way they trade—are then forced to buy VIX futures. That could spur volatility sellers to buy a bevy of alternative financial instruments as they desperately seek to rebalance their portfolios.
"The VIX futures market may struggle to absorb the demand for long volatility and dealers would be forced to rely on other sources for forward volatility," Cole says. "Dealers seeking to plug the liquidity gap would then purchase S&P 500 options and forward variance swaps. In a hypothetical disaster scenario, the excess buying pressure exerted from the short-volatility complex spilling over to S&P 500 options may push spot-VIX higher contributing to panic selling in the underlying S&P 500 index and a vicious self-reinforcing cycle of fear followed by horror."
While many will debate the notion of volatility in the VIX itself feeding into the wider stock market, it's certainly worth asking whether the increasingly erratic behavior of implied volatility itself could end up biting the plethora of volatility-related products and trading strategies now built on top of it.
"VIX term structure inverted at the greatest degree in history in August, so much so and so fast that many structured products that use simple historical relationships to gauge term structure switching and hedging ratios just couldn't handle it," Cole said in an interview.
He added: "With the growth of the short volatility complex there has been a significant distortion backed by moral hazard and embedded expectation of central bank support. If that support doesn't come through in the next volatility event, we could see an extreme reaction."
Daily
$VIX... "Black Swan"
Join the InvestorsHub Community
Register for free to join our community of investors and share your ideas. You will also get access to streaming quotes, interactive charts, trades, portfolio, live options flow and more tools.
