NEW YORK (IFR)—Hedge funds have levered up their short plays on VIX futures to such extreme levels that the market is poised for a significant short squeeze.
According to the latest available Commitment of Traders data published by the U.S. Commodity Futures Trading Commission, the hedge fund community is currently net short the CBOE's Volatility Index (VIX) to the tune of $85 million vega notional via futures contracts. That level is down slightly from $108 million at the end of January.
In June, that net exposure was zero — and the swing in exposure means a short squeeze on the VIX is likely if not inevitable.
"In search of income, hedge funds have been steadily levering up their positions to short the contango of the VIX futures curve over the past several months," said Ramon Verastegui, head of engineering and strategy for the Americas in the global equity flow group at Société Générale. "This short net position is becoming significant, and any market correction can easily lead into a short-squeeze as hedge funds look to get out of their positions."
As the VIX shows its first signs of life this year in the face of political risks in the United States and Europe, the potential for a reversal of hedge fund positioning to exacerbate any volatility spike resulting from a major event remains a real one.
The Italian election was the main driver behind a volatility spike on Monday [Feb. 25], but while fears were raised by the event, it didn't prove enough to trigger the short squeeze.
After breaking 15 for the first time this year at the end of last week, VIX followed up with a 34 percent spike on Monday to end the day at 18.99 as a record 302,278 futures contracts changed hands. The index was trading below 16 on Wednesday [Feb. 27] morning.
With the VIX hovering around record lows through the first two months of 2013, generally between 12 and 14, monetizing the contango of the curve has been a no-lose situation in the early part of the year. But strategies that