I am pretty sure no one will like today’s post. Half of my readers will be disappointed by the discussion of VIX product intricacies, and the ones not put off by the technical nature of volatility pricing, will throw bricks at me because I don’t subscribe to the notion there is a giant VIX short position ready to cover in a sickening swoosh higher when the day of reckoning finally descends.
Before we start, let me posit two points. The first is obvious. The VIX is currently quite low. Over the past few days we have even flirted with single digits. It would be perfectly natural for volatility to pick back up to mid teens in the coming weeks. I am not ruling that out, so when you read my post, please keep that in mind.
My second caveat is that I am by no means a VIX expert. In my former life, I traded stock index options on an institutional desk, so it’s not like I am a complete noob, but there are a myriad of really smart people who know way more than me. Many of these individuals have the opposite viewpoint than mine, so there is a decent chance I am way off base with my analysis, but making a fool of myself with an out of consensus view has never stopped me before, so why start now?
The narrative overwhelmingly embraced by most of the street is that there is a monster VIX short position out there, and that this volatility selling is a disaster in waiting. This camp has some impressive alumni. For the past year, the smart as a tack Jesse Felder, has been writing pieces about this risk. If you want to understand his point of view, check out the article from last summer - “The Short Vol Trade has gotten completely out of hand”. I love Jesse’s writing, and taking the other side of his trade gives me pause, but I respectfully suggest he might be wrong on this one.
It seems to me that the VIX bulls’ main argument focuses on the belief there is a huge amount of volatility selling occurring. Their main piece of evidence centers around the dramatic increase in VIX long ETF product short interest.
Here is a common “nightmare” VXX ETF chart that gets passed around.
Holy shit! That does look scary. Short interest going from under 15 million shares to 65 million in less than a year.
But instead of hyperventilating about this, let’s step back and take a moment to think.
Let’s start with the fact that during this time the price of the VXX ETF went from $50 to $15, so let’s redraw the chart with the notional amount of VXX sold short instead.
But, but, but… Suddenly that doesn’t seem quite as frightening.
I can hear the VIX bulls’ next argument already. The short interest versus current shares outstanding is almost 100%, so that represents a ton of pent up buying that needs to be covered. Sure, maybe it is less in notional value, but there is still a sizable short position that will need to be bought.
There is no disputing the fact that approximately 100% of the VXX float is sold short. In a regular stock, this would be insane. Eventually this short position would need to be covered, and the market would be correct to worry about a short squeeze.
But VXX is not a regular stock. It is an ETF. And ETFs can be created and redeemed by market makers.
When I worked as an institutional ETF trader, we didn’t worry about having inventory to fill buy orders. We knew that if we needed to, we could always create ETF shares as the need arose. So we wouldn’t think twice about selling short the ETF, and hedging it with a long position in the underlying index. Our actual ETF versus underlying position had more to do with dividends, tax and borrow rates than anything else.
I am not familiar with dealers’ biases in terms of their VXX inventories. Yet it sure seems the short position is merely a reflection of the shares outstanding. The two are moving hand in hand.
If I had to guess, I would argue that, contrary to what is widely believed, end users are not actively selling short VXX. Instead, the exact opposite is occurring.
End users are buying VXX by the fistful. Dealers are shorting the VXX to them, and as need arises, they are creating more.
I understand that this is exactly contrary to what everyone is shouting about. This would mean that instead of a sizable short position in VIX, there might actually be a big long.
Here is where it gets complicated. For every VIX buyer, there needs to be a VIX seller. And even though dealers could attempt to hedge it in the underlying option market, again, every option seller needs an option buyer. And then from there, it really depends on which party is delta hedging, and which is letting the risk run. So the real question is who are the buyers and sellers.
I agree with many of the VIX bulls’ who claim there is pervasive volatility selling occurring by institutions looking to pick up yield in this NIRP environment.
But on the other hand, there is equally massive volatility buying by retail and speculative accounts who believe the next crash is right around the corner. This is why VXX shares outstanding is exploding higher.
If there was truly a bias towards volatility selling, then the XIV’s (which is the short volatility ETF) shares outstanding should be exploding higher as retail chase the hot product. Yet, instead, the shares outstanding are collapsing.
I am aware that these ETF products represent only one portion of the VIX trade. There are futures on VIX, and even more complicated institutional products, like variance swaps. Maybe there is a monster short volatility position out there at the OTC level that I am unaware of. I am not ruling it out.
But I am suggesting that the short term hot money is long VIX, not the other way round. All you need to do is look at the amount of complaining occurring about the lack of volatility. If there really was this massive speculative short vol position, wouldn’t traders be whooping it up? Instead, all I hear is moaning about the collapsing VIX.
Many traders have written about the fact that the current low VIX is not surprising given the lack of actual movement in the index. But few are able to explain the root cause.
Well, here is a thought for you. We all know the Central Banks are becoming increasingly active in the equity markets. And the most interesting part of their involvement can best be demonstrated by the Bank of Japan’s equity purchase program. The BoJ reports their equity purchases after the fact, so we know on which days they have been active. The BoJ has a definite strategy to buy on days when stocks are down on the day. The BoJ does not regularly buy stocks regardless of the price (unlike the scheduled POMO purchases previously made by the Fed in the bond market during their QE programs), but instead, the BoJ waits for weakness and stands in there with blue tickets. This has a massive dampening affect on volatility.
I don’t know if this is enough to cause the worldwide decline in volatility that we have experienced. But I also know that periods of calm are not unprecedented.
I am not some VIX super bear, who thinks all is well with the world, and that stocks are a terrific buy because the economic fundamentals are so rosy. The financial system is way more precariously perched than most believe. Yet I am not sure it will resolve itself with an equity crash and VIX explosion higher.
Eventually, I see volatility increasing, but not for the reasons most believe. I suspect we will have a 1999 style equity melt up that also includes an increase in volatility.
But that’s longer term. In the meantime, I think the weak hands are long VIX, not the other way round. I suspect we will see record lows before this is all through. Everyone is looking for a VIX explosion, I think it’s more probable that we see a VIX capitulation.
Thanks for reading,
PS: I am off tomorrow, so no ‘Tourist. Be back Monday. Have a great week-end.