This is a summary of “Volmageddon and the Failure of Short Volatility Products” by Patrick Augustin, Ing-Haw Cheng, and Ludovic Van den Bergen, published in the Third Quarter 2021 issue of the Financial Analysts Journal.
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“Volmageddon,” the February 2018 spike in volatility that wiped out short volatility strategies, illustrates the dangers of hedge and leverage rebalancing in highly concentrated and volatile markets.
What’s the Investment Issue?
A sudden rise in market volatility on 5 February 2018 led to a one-day loss of more than 90% in the value of short volatility exchange-traded products (ETPs). Traders nicknamed the event “Volmageddon.”
The authors explain how ETPs can collapse when hedge and leverage rebalancing takes place amid concentrated markets. They illustrate the risks through analysis of the Volmageddon event, in which short volatility ETPs were hit by a negative feedback loop that propelled futures prices ever higher and progressively drove down the assets under management (AUM) of short volatility ETPs.
How Do the Authors Tackle the Issue?
The authors examine ETPs that were popular in 2018 (the VelocityShares Daily Inverse VIX short-term exchange-traded note, or XIV, and the ProShares Short VIX short-term futures exchange-traded fund, or SVXY) to illustrate their cautionary tale. They also analyze Cboe Volatility Index (VIX) futures price data from Bloomberg Professional and Cboe to quantify the impact of such trading and to approximate the impact on the performance of the short volatility ETPs.
What Are the Findings?
The Volmageddon episode can be explained by a combination of market concentration and hedge and leverage rebalancing.
Both ETPs (XIV and SVXY) were designed to provide investors with a return that mirrors the inverse performance of the S&P 500 VIX Short-Term Futures Index. The authors hypothesize that when volatility spiked in February 2018, there was a sharp fall in the value of short volatility ETPs and an increase in the notional exposure of their short VIX futures positions. To remain market neutral, the ETPs needed to buy a large number of VIX futures contracts.
The purchase of VIX futures had a significant positive price impact on futures prices and led to further drops in the AUM of SVXY and XIV. This necessitated further rebalancing and, therefore, even more shrinkage of AUM.
The large market share in VIX futures contracts held by leveraged ETPs exacerbated the volatility shock, sending the ETPs’ rebalancing mechanisms into overdrive. This negative feedback loop kept pushing futures prices upward, leading to huge downward pressure on the ETPs’ AUM and, eventually, to investor losses of around 90%.
What Are the Implications for Investors and Investment Managers?
Volmageddon emphasizes the importance for risk managers and regulators to monitor hedge and leverage rebalancing strategies, especially when market concentration and volatility are high. Both the liquidity and the volatility of the underlying index of ETPs should, therefore, be critical considerations when launching leveraged investment products.
Given the risks associated with market crowding, public disclosure of the market shares of issuers would enable regulators and investors to discern increasing concentration before it becomes disproportionate.