Even as the VIX has continued to plumb new all time lows, unable to rebound from the realm of single-digits where it has spent a record amount of time in 2017, warnings about a potential surge in the volatility index have been growing in recent weeks.
Last week, in a note looking at what may happen "if the VIX goes bananas", Morgan Stanley's Chris Metli cautioned that it’s easy to become numb to the low volatility environment and the risks it presents. While trying to pick a trough in vol has been a fool’s errand, Metli said that focusing on the risks resulting from vol being so low is not, and warned that low vol has produced a regime where the risks are asymmetric and negatively convex, so being prepared for an unwind is critical. "This is not a call that vol is about to spike, but you need a plan if it does", he echoed many other similar warning issued in recent months.
Of course, while nobody can know when a VIX explosion could occur, Morgan Stanley explained what could catalyze such a violent rise in volatility, showing that "just" a 3% to 4% one-day S&P 500 selloff could result in a 12 point VIX surge, a relationship MS showed through the gamma in vol related products, where demand for VIX futures from three main sources could result in 100,000 contracts ($100mm vega) to buy in a down 3.5% SPX move. For context VIX futures ADV over the last year is 230,000 (although has risen to as high as 700,000 in big selloffs).
For those who missed it, below we recap some of the salient points of what would happens if the S&P 500 were to fall 3.5% today, based on Morgan Stanley calculations:
- First, the VIX could rise as much as 12 points. When volatility is low it tends to move a lot for a given change in the S&P 500. That effect is likely to be exacerbated now because a) skew is steep (and VIX rolls up the skew in a selloff) and b) many players in the VIX market are short. Taking these dynamics into account QDS estimates VIX could rise ~12 points for a 3.5% 1-day decline in SPX. Of course, a far smaller move in the VIX would be sufficient to result in massive losses among the vol-selling community according to previous calculations by JPM's Marko Kolanovic.
- Just as concerning, if VIX futures approach +100% in a single day, there is a risk that the providers of inverse VIX ETPs cover the VIX futures that they sold to hedge the products. This is because there is a mismatch in the hedge if VIX futures rise more than 100% – the inverse ETPs can’t go below zero (-100%) but the loss on a short VIX futures position can be more than -100%.
- For XIV (holding ~73,000 contracts short) the prospectus indicates that it will unwind if the NAV falls more than 80% intraday, with investors receiving the end of day value. Given this is a known threshold, anything close to a +80% move in VIX futures would likely trigger buying (by the ETN provider and/or market participants) in anticipation of the unwind. Note that because XIV is an ETN, investors receive the theoretical value of the index based on its rules, not what the provider actually trades.
- SVXY (holding ~37,000 contracts short) does not have a set threshold to unwind according to its prospectus. That said VIX futures currently have a margin requirement of ~45% of notional for the average of the front two contracts, and any decline in value of the inverse ETPs to those levels could trigger a rapid forced unwind. Note that SVXY is an ETF, so the NAV is based on the actual holdings of the fund at the end of the day.
- Adding to the pain – on days after the initial shock – would be the flow from annuity and risk parity deleveraging. Both of those investors are slow by comparison to the VIX market – annuities will sell over several days, starting the day after a selloff. Risk parity funds are more discretionary, and the supply could come over a matter of weeks. But given high leverage resulting from the low vol environment, their potential supply is large and could prolong any downturn. Between all three vol players, a 3% drop in the S&P would result in forced selling of roughly $60 billion in one day, growing to $140 billion should the plunge accelerate to -5% intraday.
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In a separate report also discussed here previously, Fasanara Capital's Francesco Filia revealed what the "wipeout scenario" - one in which the VIX were to double from its current level in the 9/10 range to 18/20 - would look like for vol sellers. In a word, it would be an unmitigated disaster.
Our analysis shows that if VIX goes from 9.60 to 18/20 in absolute values (it was approx. 40 as recently as Aug2015), and stays there for 8 / 10 days in backwardation, VIX-based ETFs may stand to lose up to 55%. Short positions on long-vol ETFs can then lose up to 250% of capital with VIX at 20. Losses are higher in case of wider backwardation of the term structure of the VIX (i.e. front contracts trading higher than back contracts), or the longer VIX stays elevated while in backwardation, or clearly the higher it goes. For example, if VIX quadruples from here to 40, losses on a UVXY position would amount to a staggering 656%!
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We bring up all of the above, because as Morgan Stanley said, "This is not a call that vol is about to spike, but you need a plan if it does" and at least one exchange is doing just that.
In a notice to clients sent out late on Friday, Interactive Brokers admits it is starting to get a worried about the recent VIX record lows and as a result after expiration processing on August 19, "Interactive Brokers will put into place greater margin requirements for Volatility Products."
While the IB notice had it usual dose of fluff and generic admonitions...
VIX has established new all-time lows over the course of the past month. The price dynamics of that product are such that it can have very large relative price increases over a very short period of time base on news and other market factors. In recognition of the special risk of sudden, large increases in market volatility, that is inherent in Volatility Products such as VIX, Interactive Brokers will put into place greater margin requirements for Volatility Products after expiration processing on Saturday, 19 August.
... It was surprisingly clear in what the specific parameters of the anticipated move are, to wit:
IB's margin policy will be to consider market outcome scenarios under which VIX might rise to a price of 18 (even when it is currently priced much lower) and under which the other Volatility Products could rise to proportionately similar degrees.
In other words, IB is starting to prepare for the day that the VIX doubles from current levels, which as Fasanara showed above, is sufficient to wipe out most vol sellers, and in the case of those with levered, naked volatility shorts, results in losses greater than 600%.
Who will be impacted:
If you have positions in Volatility Products that have risk in large upward moves of market volatility, then your margin may increase significantly.
Of course, since volatility is the "fulcrum security" of today's reflexive market nature - does a surge in the VIX send stocks lower, or does a market crash lead to a VIX surge? - the very fact that vol-linked leverage is about to be aggressively cut first by one, then by many more if not all exchanges, as we head into the critical for volatility fall period, these warnings could create a self-fulfilling prophecy whereby the margin increases are the very catalyst that leads to a surge in volatility.
Whether that is what happens over the next two weeks remains to be seen. In the interim, IB said that "it will with immediate effect increase its Initial Margin requirements on Volatility Products to a degree consistent with the upcoming 19 August increases in Maintenance Margin."
What this means is that vol sellers will now have to pay up substantial additional margin (i.e. cash) for new short-vol positions, and that in two weeks, maintenance margins for legacy positions will be likewise affected. It also means that unless the short-vol traders have a generous amount of cash lying around, they will have no choice but to close out of existing positions, in the process sending vol, and VIX, higher if purely mechanistically.
IB also specifically cautions inverse vol sellers:
Some Volatility Products have "ultra" and "inverse" characteristics. Ultra products are expected to have greater daily returns than normal products while inverse products are expected to have returns that are of the opposite sign to normal products. It is therefore expected that an increase in market volatility will result in a decrease in the price of an inverse volatility product. As a consequence, for example, under the new policy the margin on a naked short call will increase for a normal product while the margin for a naked short put will increase for an inverse product.
This unexpected margin hike across the vol universe by Interactive Brokers (to be followed by its competition) is especially notable because one month ago Bank of America warned that the most dangerous moment for markets "will come in 3-4 months", or 2-3 months as of today, when the confluence of the adverse debt-ceiling negotiation, disappointing Q3 earnings, and the Fed's balance sheet unwind all converge into one broad risk-off shock.
It is precisely this "event" that Interactive Brokers is the first to admit may have drastic consequences on the market.
IB's full notice is below.