Stability Breeds Instability

by: Arcadia Research

Last week's massive inversion in the VIX curve was the largest since 4Q.

These "flash crashes" are becoming more and more common in the post-GFC era where volatility is continually suppressed.

Systematic selling, poor liquidity, dealer hedging, and a record amount of short vol futures all played a role in last's week drawdown.

It’s all fun and games until a single tweet throws a giant curve ball to global markets whom all but assumed a trade deal was inevitably going to happen last week.

For those wondering why we’re seeing more & more of these “flash crashes”, I wanted to lay out a few potential scapegoats, but before we get to the potential causes let’s take a quick look at what happened.

Last week, the VIX curve dramatically inverted after US/China trade relations started to heat up with Trump threatening higher tariffs if a deal wasn’t reached. This happened at a time when speculators were record short vol futures (see chart below). One could argue that these short positions are offset by increasing AUMs in the long VIX ETP complex, but regardless, there was a record amount of short vol futures positions.


(Arcadia Research, Bloomberg)

What was interesting was that the VIX spiked nearly 10 points on a relatively modest selloff in the market (SPX down -4.5%). In fact, according to Nomura, it was the second biggest move in the VVIX/VIX ratio since the Vol-pocalypse in February 2018, which means that the volatility of volatility was unusually high compared to the volatility of the stock market.

The aforementioned point on VVIX- and Skews- still at such extremes obviously iterates the outperformance of VIX vs S&P; i.e. per the previous two year look back as “standard,” yesterday’s SPX performance “should have” seen VIX close at 15.95—but instead, it closed at 19.32 (and +47.3% WoW), which captures the relative extremes of the “short vol” unwind which behind the VIX futures curve inversion.



Further illustrating the rarity of the situation, Goldman noted: “Term structure inverted sharply, skew spiked, and the VIX’s increase significantly exceeded what realized vol or the spot sell-off would imply…”



The fact that the VIX spiked so dramatically on what was a relatively modest drawdown in the market is a testament to the post-GCF era where volatility is sold, not bought. The Fed (as well as other DM central banks) has effectively suspended normal market functioning by cutting interest rates / pumping money into the system over the last decade, which has led to a continual suppression of cross-asset volatility as investors ventured out on the risk curve in search for yield.

The market has become so accustomed to this “lower interest rates / flatter curves forever” theme that it’s been engrained into the investment process for many systematic strategies / vol-control strategies / risk parity / CTA’s. This is important because these strategies make decisions (trades) without emotion and with a lot of leverage behind them so when the VIX spiked last week many systematic strategies automatically hit the sell button and sent the VIX even higher at which point triggered a short vol unwind and further exacerbated the move.

Here’s a chart of the SPX Daily Risk Control, which is a proxy for vol-control funds. Albeit not a large drop compared to 4Q, but you can see the quick drop circled in red.


(Arcadia Research, Bloomberg)

And here’s a chart of the TICK index, which shows upticks minus downticks on the NYSE. Anything over 1000 in either direction can be indicative of indiscriminate buying/selling. You can see that on May 7th we saw a large selling program around 1pm.



It’s also worth highlighting that market depth / liquidity hasn’t really improved much since the 4Q bloodbath. Goldman pointed this out recently saying: “As volatility subsided in April, SPX futures’ top-of-book depth did not quite get back to the level they reached in September, just before the Q4 sell-off.”



This is important because liquidity essentially disappears when the VIX spikes, which further intensifies the amplitude of the move. JPM noted this dangerous relationship in early January: “The relationship between liquidity and volatility is very strong and nonlinear e.g., market depth declines exponentially with the VIX.”



In addition to poor liquidity, automatic deleveraging from the systematic community and a record amount of short vol futures positions, it’s important to also keep in mind the effects of dealer hedging. Typically in a trending higher type of market, you can assume that short-volatility strategies are proliferating and dealers are getting long gamma. However, in market selloff we reach a point where as the market goes lower dealers are getting wrong-sided and have to actually keep selling more to maintain their hedges, further exacerbating the move.

Here’s a visual from Nomura estimating when dealers were forced to become sellers resulting in a “negative gamma” feedback loop.



So there you have it. Between systematic selling, poor liquidity, dealer hedging, and a record amount of short positions, we saw a massive inversion in the VIX curve amongst a quick -4.5% drawdown in equities.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.