Options Trading: Volatility Explosion Breaks Market

Posted On February 6, 2018 12:46 pm

There’s a well-known image of a turkey’s life that could just as well illustrate what happened to those who have feasted on shorting volatility in their options trading over the past few years.

Basically, they were getting fed, fat and happy until your head gets taken off.

And yesterday, that hatchet came in the form of a 115% surge in VIX.

It’s been widely reported and well-known that stock market volatility has been on the decline for the past few years. In the weeks heading into the end of 2017, it sank to historic lows.

What the average investor may be less aware of is that options trading professionals have increasingly been placing huge bets that this volatility will remain benign. Some of these trades are based on market fundamentals and thought-out hypotheses. But a good portion of these bets are simply based on the structure, some would say flawed, of volatility-related products such as the VXX, which have a built in propensity to head toward zero. This gave people the confidence to sell volatility and options with impunity.

The proliferation of such bets has some market observers worried that when there is a sustained lift in volatility, it will cause a conflagration likely to spread into uncontrolled losses. Naturally, this has serious implications for future options trading. Here is the Financial Times’ take on the situation:

Financial markets had been remarkably tranquil over the past year but a number of market veterans from InterActive Broker founder Thomas Peterffy who warned in Barrons back in 2010 that the a build-up of bets on derivative ETFs and ETN especially those based on volatility could threaten market stability that could unravel spectacularly when turbulence reappears.

The upshot is that as pension funds and even some hedge funds sought to find steady income or yield in the zero-interest rate environment they increasingly betting against volatility to invigorate their returns. “There are so many people in this short volatility trade that it’s breaking the plumbing on markets and they’re not reflecting the risks,” says Adam Sender, head of Sender Company and Partners, a hedge fund.

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What we’ve created with is complex and intertwined series of products in which the bets being placed in the volatility products were hedged against other related products and ultimately the whole ball became as Zero Hedge describes One Big Trillion Dollar Bet.

Essentially the derivative bets become larger than the size of the underlying market.   This is not unlike what happen during the housing crisis as the mortgage backed CDOs ballooned beyond the value of the underlying assets.

What makes the volatility based products even scarier is they are backed by any tangible asset and they come with built in structural flaws which can lead to an escalation of a negative feedback loop or what George Soros famously referred to as reflexivity .

That tightly coiled ball burst its seems and become unwound yesterday.

Steve Place had a great and prescient article describing how volatility markets were broken and the systemic risk the presented.

What occurred yesterday, when the VIX surged by more than 100% it cause those short volatility to become even shorter due to both gamma and vega risk which caused losses to multiple at an ever faster rate as the position goes against you.

This forced them to hedge, buy selling S&P 500 futures or SPY shares—or buying index puts or VIX futures.  All of which exacerbated the situation.

Ultimately the system broke and ETNs such as VelocityShares Daily Inverse VIX Short Term ETNs (XIV) had forced liquidation leading to termination event or shuttering of product.

Like the turkey, it had short and happy life that had a swift and terrible ending.

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About author

Steve Smith

Steve Smith have been involved in all facets of the investment industry in a variety of roles ranging from speculator, educator, manager and advisor. This has taken him from the trading floors of Chicago to hedge funds on Wall Street to the world online. From 1987 to 1996, he served as a market maker at the Chicago Board of Options Exchange (CBOE) and Chicago Board of Trade (CBOT). From 1997 to 2007, he was a Senior Columnist and Managing Editor for TheStreet.com, handling their Option Alert and Short Report newsletters. The Option Alert was awarded the MIN “best business newsletter” in 2006. From 2009 to 2013, Smith was a Senior Columnist and Managing Editor for Minyanville’s OptionSmith newsletter, as well as a Risk Manager Consultant for New Vernon Capital LLC. Smith acted as an advisor to build models and option strategies to reduce portfolio exposure and enhance returns for the four main funds. Since 2015, he has worked for Adam Mesh Trading Group. There, he has managed Options360 and Earning 360, been co-leader of Option Academy, and contributed to The Option Specialist website.

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