A 2-3% Correction Could Wipe Out Most VIX Short Sellers

[sle]

For every seller of a future there is a buyer.

While that’s true, it’s worth distinguishing a speculative position against a hedge one. In case of equity vol, the “chain of custody” is roughly as follows:
1. Equity owner buys an index put outright
2. Dealer index desk that has sold the put hedges delta and covers the convexity
3. That convexity is sourced from various vol sellers including VIX futures shorts

So yes, you could have an imbalance of speculative shorts against hedging longs. If you do assume that a large fraction of open interest in the front is a speculative short (say 75% of roughly 500k) that’s a sizable position. A big portion of that is in leveraged ETPs, which are not vega-1.

It’s not an apocalyptic scenario, but if S&P does move 2-3% down in a day (a fairy moderate move, all things considered), it could trigger a chain of covering and a lot of people will be left in tears.

 

[algotrader12]

Well, yes it is a risky trade, I get it. And if you are not properly hedged, you will get hurt. I just don't see this as some kind of systemic risk as a lot of people are trying to present it.

Sure a 2-3% daily drop will turn ugly for vol sellers, we have already seen couple of intra-day spikes of vix I think to 16-17 and people quickly rushed to cover. Everything has been orderly and I did not see any panic look at drop in open interest when vix spiked, people took some losses and covered.

Vix futures have always been extremely volatile. Truth is when VIX was @ 15, there was always a risk that it can spike to 30 or 40, so there is nothing new, if you are not ready for those spikes you will get run over, futures are lower then usual, but realistically nothing has changed.

Don't forget global economy has improved, Unemployment is at multi year lows and we have a global growth of epic proportions taking place right now. So its reflected in more people being long market and short volatility.

So lets look at a potential 2-3% SPX drop. So here is the worst case scenario imo. VIX goes to 18, front future to 16 and back future to 14-15, the rest of the curve will move up but only slightly. So if you are short 2 front month in VIX you will get hurt, but then again of you are short those month, you always needed a game plan in place. So nothing has drastically changed the way I see it.

 

[i960]

Don't forget global economy has improved, Unemployment is at multi year lows and we have a global growth of epic proportions taking place right now. So its reflected in more people being long market and short volatility.

You're either short VIX, new here, or both if you actually believe the above.

We've been over this a million times. Everything is about central bank accommodation, corporate financial engineering, and tails (heh) wagging the market dog. You don't have to be reading ZH every day but you should be questioning the current reality when it comes to "fundamentals."

Aside from all that, short vol is being approached as a "can't lose" trade by retail and other entities. We know how this movie ends.

 

[algotrader12]

And what exactly is your point? Central bank accommodation has been a theme for past 10 years, if that was your fear then you missed out on a huge rally, what was your solution? staying in cash and fixed income?

 

[i960]

And what exactly is your point? Central bank accommodation has been a theme for past 10 years, if that was your fear then you missed out on a huge rally, what was your solution? staying in cash and fixed income?

What does any of this have to do with anything? I'm simply addressing your implied point that everything is wonderful and that's why indexes continue to go up and vol should be sold.

 

[algotrader12]

Nothing is wonderful, Point I am making is, nothing has really changed market is slightly higher and vol is lower and few more people are short vol, big deal, I don't get all the noise around it. Everywhere I look they scream about vix being at 9 and is about to explode and destroy everything around us, it has always been this volatile thats all I am saying.

 

[i960]

Everywhere I look they scream about vix being at 9 and is about to explode and destroy everything around us, it has always been this volatile thats all I am saying.

What do you mean "it has always been this volatile?" The long term average VIX is not 9 dude. It's not 15 either.

Let me address one of your earlier statements:

So lets look at a potential 2-3% SPX drop. So here is the worst case scenario imo. VIX goes to 18, front future to 16 and back future to 14-15, the rest of the curve will move up but only slightly. So if you are short 2 front month in VIX you will get hurt, but then again of you are short those month, you always needed a game plan in place. So nothing has drastically changed the way I see it.

Yes, things have changed. The amount of retail and other money currently pumped into shorting the front end of the VIX curve every single day without question is significantly higher than prior cycles (let's say pre-08, or even pre-2012). "So if you are short 2 front month in VIX you will get hurt, but then again of you are short those month, you always needed a game plan in place" <-- which is precisely where they're short with a plan of "short vol always wins."

 

[algotrader12]

Long term average is not much higher from 15, but then no one really cares about the spot, when it gets short vol trades, its all about the futures and thy are higher then 9. ( Yes lower then normal but not 9, so who cares if spot is @9)

Whoever trades futures understands whats evolved, if not its their own damn fault. The only real way retail customers have today to short vol is to buy things like xiv/svxy as shorting vxx/uvxy became hard. Most of them have 5-10% allocated to this paper. So you are telling me this will destroy the market? OK lets look at these scary vol ETPs:

lets look at the most popular ones and their market caps:
VXX - $1B
UVXY - 500M
XIV - $1B
SVXY - $1B

There are more but they are all tiny. So what exactly are we talking about here ? $4-5B? its a drop in a bucket, I don't see how can any of this affect market in any major way.

 

[Overnight]

...Don't forget global economy has improved, Unemployment is at multi year lows and we have a global growth of epic proportions taking place right now. So its reflected in more people being long market and short volatility.
...

The "global economy" has been improving for thousands of years. This does not mean that volatility stays low. A few major events in a row will increase the fear, thus the "VIX". Keep shorting into those lows, I dare ya'!

 

[newwurldmn]

Vol is always lowest before it spikes.