What exactly happened last week? Did the equities sell-off spark a spike in the VIX and blow out the billions of dollars shorting the VIX? Did the over-weighted short volatility traders lead to a further sell-off in equities? Or is this a standard 10% correction in the markets; something that's not that uncommon.
We're no experts in VIX and volatility trading, but we did ask those that trade millions in VIX Futures to give us some insight. We reached out to Tim Jacobson, manager of the Pearl Capital Advisors - HEDGED VIX (QEP) program, capturing a +30% performance last week to get some answers. Where did Pearl go right, where so many went wrong?
Here is our conversation with Tim:
1) Is the VIX spike an example of the tail wagging the dog? How much do you think VIX ETPs blowing up had to do with the moves in equities?
Tim: On the back of the release of the wage inflation data, markets processed the expectation that increased wages could place a drag on corporate profits. This inflation is having its impact in interest rates and spilling over into equity markets. Equity markets are trying to figure out how much of an impact this will have and therefore began the adjustment of those expectations last week and this week. Our analysis is that volatility will be higher than what it was in 2017, regardless of the direction of equity markets. Many cases exist of rising volatility in conjunction with rising equity markets - see the 90s as an example. It is likely that as fiscal policy takes effect, it can potentially restore pre-QE market dynamics characterized by healthier advances and declines, punctuated with a higher base-level in volatility.
The equity sell-off was not caused by the unwind of the short-vol trade. Rather, the equity sell-off caused a capitulation in the short-vol complex. At the close of equity markets on Feb. 5, VIX Futures were up 8-9 points. However, as equity futures continued to sell-off into the close of the equity futures session, short-vol-sellers faced potential margin calls and the fear of follow-on selling. This sparked a stampede into the futures settlement, causing VIX Futures to rise to +17.6 points on the day. In the last 15 minutes, VIX Futures effectively doubled and proved to be the biggest one-day point move in the history of the VIX Futures. We saw the first shot across the bow in August 2017 when this same dynamic occurred and our Program logged substantial gains that day. Now we have seen an even bigger portion of the unwind. It will be interesting to see if short-sellers get brave again and reload for another unwind or not. But there are still a massive amount of short-vol products that can still provide a powder keg.
2) Most of the volatility traders are not having a good February. Can you walk through how your program found positive returns?
Tim: The pain experienced by volatility traders who elect to sell premium can be explained by classic market conditioning and frame dependence. For the last several years, premium-sellers have been repeatedly validated by the market to sell premium. The recent low volatility environment beginning with the Trump election also conditioned managers to sell whatever premium that market was giving them and that any market dips were merely opportunities to reload. However, at some point that dynamic will change.
3) Do you think an environment of higher volatility is good for volatility traders?
Tim: Higher volatility is generally better for our Program as we have a long gamma profile over the long term. This spike in volatility seems to break with the those of the last few years. Typically, volatility increases have been fleeting and fickle. They have tended to be simple one to two day events. However, this is the longest we have seen VIX rise above 20 and stay above it for quite some time. This should provide ample trading opportunities to exploit behavioral inefficiencies in volatility markets. However, just as in the slow process of changing market psychology over multiple selling attempts, increasing to a higher volatility regime won't come in just one episode. We believe August 2017 was the first volley to shake out the short-sellers. This episode looks to have been the second. We would expect another wave of unwind to occur.
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