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In market storm, a rush to trade volatility itself

Michael Santoli
Michael Santoli

You can’t sit in the ER and wager on cardiac patients’ chances, hang around the airport laying odds on emergency landings or stand on the beach and bet on a hurricane's windspeed.

But on Wall Street, buying or selling the probability of market morbidity and mayhem in real time is fair game – and this month’s mini-panic in stocks propelled this so-called volatility trading to new heights of popularity.

This isn’t about the trading in volatile stocks or commodities, but in funds, futures and options whose value is linked solely to a statistical measure of expected market jumpiness, known as the VIX.

From Oct. 10 through the 16th, the Standard & Poor’s 500 index went from 1928 down to 1820 and back up to 1868, while the VIX popped from 15 to 31 back to 25, in the most severe market storm to hit in around three years.

During those five trading days, more than $100 billion changed hands in instruments based solely on the VIX -- a statistical measure at least three steps removed from any corporate security or economic entity.

1-year VIX chart

While dollar volumes for VIX derivatives are not routinely tracked, I asked researchers at CBOE Holdings (CBOE) – which runs the exchange that lists the products – to estimate dollar flows based on daily VIX levels and contract volumes.

VIX futures and options on those five days totaled about $90 billion in turnover, comprising both trades positioning for higher and lower VIX. Also, various exchange-listed funds did more than $25 billion in volume, the vast majority in the iPath S&P 500 VIX Short-Term Futures (VXX).

There is some double-counting here since VXX “owns” VIX futures, but the point stands that overall volume in volatility products exploded in the market drop, more than tripling activity levels of the week before.

For some perspective, if $100 billion in cash had washed out of equity mutual funds or junk-bond funds in an entire month, let alone five days, it would be considered an historic level of investor panic.

Richard Repetto, analyst at Sandler O’Neill who covers the exchange and electronic-trading industry, calculated Friday that month-to-date average daily volume in VIX futures was more than double that of September, and was nearly quadruple levels of two years ago.

In the month through last Thursday, a net $365 million had entered listed volatility products, and their collective assets under management were $3.9 billion.

What is the VIX, exactly?

The CBOE S&P 500 Volatility Index, as the VIX is formally known, uses stock-index options prices to determine the market’s expectation for market volatility over the next 30 days.

When VIX is rising, it means large investors are paying ever more for protection against potential stock market declines in the near term, and vice versa.

As an indicator, the index has proven useful at identifying the shift between bullish and bearish market environments, between fear and complacency, and when it surges to an extreme high and then retreats it has tended to be a decent signal of a short-term market low. Many analysts have constructed sophisticated market-prediction models based on the shape of the "VIX futures curve," too.

The index has been around for more than 20 years and has been calculated back to 1986. But futures and options on the VIX have only been listed in the past decade, and the handful of exchange-traded funds tied to it began appearing in early 2009.

On paper, this is a victory for the finance industry in disaggregating the components of asset markets, allowing investors to hedge or speculate efficiently on attributes of the markets that can impact portfolios.

Before these instruments, traders would need to use less efficient proxies such as options or particular stocks themselves to capture changes in expected market volatility. Or, they’d execute volatility trades over the counter with banks in an opaque and less liquid venue.

Potential for misuse

Still, when a thing becomes tradable it invites potential misuse. Trading volatility amounts to short-term market timing - a loser's game for most - but is even harder than simply playing market direction. It requires getting the direction, timing and degree of a move roughly correct.

The VXX, to cite a popular retail-trading product, is just about built to erode in value over time. Every day it rolls futures positions from nearer-dated to longer-term contracts. Because VIX futures prices are (usually, though not currently) higher at later dates, the fund systematically “sells low and buys high."

This is not a problem for traders using VXX to express very short-term views on volatility, especially for intraday positions. But it makes the fund a terrible buy-and-hold vehicle, and too many investors seem to think it can be stashed in a portfolio as an ongoing hedge, as its steady asset base of more than $1 billion attests. The fund has done repeated reverse splits to keep from approaching zero. Adjusted for these splits, VXX – now trading around $36 – began life around $7,000 in early 2009.

The continued popularity of such highly engineered ETFs helps explain why Janus Capital Inc. (JNS) – a firm steeped in stock selection that just hired Bill Gross to run a bond portfolio – last week agreed to acquire the firm that runs VelocityShares, which has funds that hedge using VIX futures.

It also helps explain the relative strength of the shares of the CBOE and competitor CME Group (CME), which are up 10% and 7% the past three months, compared to a 4% decline in the S&P 500. These exchanges do better as volatility, trading volumes and the demand for hedging rise.

Finally, the fact that such products can be produced almost out of thin air means the profit-seeking exchanges will keep creating more.

The CBOE next month is set to introduce futures on the 10-year Treasury Note Volatility Index, known as VXTYN, which will also let traders play changes in the volatility of perhaps the world’s most traded security, just as the Federal Reserve’s future policy course is being hotly debated.

Repetto notes that the over-the-counter derivatives market for interest-rate volatility is about 40 times as large as the one for equity derivatives that the VIX products draw from. Buckle up.