Posted by on November 26, 2017 12:00 am
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Categories: Arbitrage bank of america Day trading Economy Finance Futures contract Hedge Mathematical finance money New York Times Real Vision Reality S&P S&P 500 S&P/ASX 200 VIX Technical Analysis VIX Volatility Warren Buffett

Back in August, we highlighted a story in the New York Times about a former manager at Target who decided to try day trading with $500,000 he had saved up. Over the following years, he turned that into $13 million by following one simple strategy: Shorting volatility every time it spiked.

As MacroVoices host Erik Townsend points out, that strategy has worked for many retail investors over the past eight years. And in a brief “postgame” interview with the Macro Tourist Kevin Muir following a longer interview with Francesco Filia, a fund manager at Fasanara Capital, the former explains how many investors don’t understand the risks associated with shorting volatility, as well as the possible repercussions if exchanges and brokerages don’t take the appropriate steps to limit this.

Townsend begins the discussion by asking Muir about a chart he created of the VXX – the long-VIX ETF – which, because of the low-volatility environement, has repeatedly split leading to unbelievable wealth destruction.

Going back to 2009, the price of the ETF has gone from $120,000 a share to just $35. And while a sudden spike in volatility could see it surge, with so many investors on the other side of the trade, it’s worth considering what might happen if they couldn’t pay.

It’s frightening. And I don’t think enough people are – well, there are some – but I don’t think that enough people are really considering all these things. And I think that guys like the Interactive Broker chairman, that are taking proactive steps to make sure that there’s enough margin, we need to see more of that. We need to see more people saying, hey, wait, this is actually a very, very scary instrument that has a lot of risk in it.


I watched a Real Vision interview with John Hempton from Bronte Capital, and he talked about phoning up the infamous Target salesman guy, the fellow that quit his job as a Target manager to trade XIV and all the VXX products, and he turned his 1/2 a million bucks into 13 million bucks. The part that really scared me about it was that John phoned him up and he was expecting to talk to this very sophisticated guy, and his basic takeaway was that, although he had a lot of buzzwords, and he understood kind of what the products represented, he didn’t really understand his true risk.


And I think that there’s just a myriad of people out there that are trading these things that don’t understand that. The more people that wake up and realize this, and stop playing this game, the better off we’ll be, actually.

Brokerages have caught on to this, Muir says. Interactive Brokers, one of the largest online brokerages, is now asking retail investors to post between 300%-400% margin when they short certain VIX contracts – because brokerages recognize that one sharp drawdown in the S&P 500 could blow millions of short traders out of their positions, potentially leaving thousands of customers with massive negative balances that could threaten the brokerages’ existence.

Erik, you’re absolutely correct. And Interactive Brokers, one of the largest electronic brokers out there, realizes the risk. If you look at the way that they’re margining these products, they’re margining them completely different than what the exchanges and everyone else say is the proper amount.


So if you look at the VIX futures, the front month is $6,200 – the exchange minimum is $6,200 – which works out to roughly 50% of a contract. The next month is $4,000, which works out to 30% of a contract. And the far months are $2,500, which works out to 17% of a contract.


But if you go to Interactive Brokers and you want to sell this VIX contract short, you have to put up 300%–400% of the contract. Because they’ve looked at it and they’ve realized that if the S&P has a 10% down move, which isn’t out of the realm of possibility, that the VIX could spike up to 37 really easily. And people are going to be wiped out if that happens.

Should the VIX suddenly spike, the repercussions of such a move would be further complicated by the billions of dollars sitting in various VIX-linked ETFs. Because individuals sellers would probably disappear from the market in such a situation, the ETF market makers would find it nearly impossible to hedge their positions, potentially triggering the dissolution of the funds, or even the collapse of some of these firms.

There’s $1.2 billion of the XIV, which is the short ETF. There’s $1.3 billion of the SVXY, which is another short one. These are staggering numbers.


In my days, when I was on the institutional desk, we had this big – I did index arbitrage, and we used to go out and buy the baskets and sell the futures. One day the risk manager came to me and said, if you had to take this position off (because we had accumulated this big position) how long would it take you? And who would do it?


And I said, the reality is that there’s nobody. You know, we were the biggest player in the market and there was nobody that was going to take this off of us. The only way was to go all the way to expiry.


Well, the reality is that these numbers are way bigger than any market player can absorb. And, if we get a situation where – as Francesco says, all it’s going to take is a return of the VIX from its current level of 10 to its average level of 18 or 19 to wipe out these products.


I guess that’s the point that I want to make: If you’re actually owning these things, you should be aware that all it will take is a move of 80% and then they’re going to wind down these products. So the XIV, when it moves up, if all of a sudden VIX goes from 10 to 18 in a day, they’re going to wind down that product.


And what’s going to be really scary is the amount of VIX futures that is going to have to be bought, because they’re short all those VIX futures and they’re going to have to buy them back.


And I just don’t know who’s going to sell it to them. For the first time – for a long time, I didn’t view this VIX as that big a deal, and there were some smart guys like Jesse Felder that were going on about it – I just think that it has been taken to a level that is becoming increasingly worrisome. And it actually could create a market dislocation in itself.


And what is it Warren Buffett says? What the wise man does in the beginning the fool does in the end. Well, VIX, at this point, we’re hitting a point where if you’re actually continuing to bet on it you’re going to be in the fool category.


Because it’s not going to take much to have a big spike that wipes a lot of people out. And it’s actually very, very worrisome.

Of course, it would take a large intraday move to trigger a truly catastrophic spike in the VIX. But at least one analyst, Bank of America’s Michael Hartnett – whose work we have cited here – believes there could be a 1987-style crash in the early months of 2018. Hartnett’s reasoning? The bearish positioning seen at the beginning of 2017 has completely flipped. Investors’ long positions are larger than they’ve been in years.

And as we’ve repeatedly pointed out, with volatility and volume so subdued, hedge funds have remained overwhelmingly short vol, fearful of missing out on even one tick of the torrid rally for fear of pissing off their clients.

One things for certain: Given the market’s already dramatically overextended rally, the day of reckoning is coming. The only question is will it be a steady decline, or will it happen suddenly?

Given the incredibly stretched nature of positioning, the latter scenario, Muir and Co. believe, seems far more likely.

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Muir’s discussion begins just after the hour mark:


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