It used to be that investors viewed volatility as simply a risk to the predictability of a price at any given moment. But increasingly, investors view volatility investments as a way to protect against downside or as investments in themselves.
The most popular way to measure volatility is to use the VIX Index. Managed by the Chicago Board Options Exchange (CBOE), the VIX is designed to reflect investors’ expectations for stock market volatility. The VIX is a derivative of a derivative; the math is beyond the understanding of most people. Every 15 seconds, the VIX is calculated using a weighted set of options for S&P 500 futures to estimate how much investors think the stocks index will fluctuate 30 days in the future.
Investors large and small have looked beyond the VIX’s complexity because they have found it an irresistible way to make money.
When investors are expecting a stable market, the VIX is low and the opposite is true when investors are expecting instability. The historical average value of the VIX is around 20, although it has spiked beyond 100 in shock events like the 1987 Asian financial crisis, the global financial crisis in 2008, and smaller events like the 2011 earthquake in Japan. In 2017, the VIX averaged less than 10, which reflects unusual and unprecedented stability.
While this has been good for some investors, it has also make others very nervous. The economist, Hyman Minsky, has said “stability breeds instability.” And that has made many investors concerned that this long period of stability will be followed by instability. And that instability could be very costly for some volatility investors.
Investors bet on volatility in order to make money when the market is volatile. They also bet on volatility as a way to protect against downside in other investments.
For instance, investors will bet on the VIX going up to protect against losses when the S&P 500 declines. This protection (a.k.a. this hedge) works about 80% of the time—since the VIX moves in the opposite direction of the S&P 500 about 80% of the time. But betting on volatility costs money because investors are constantly moving their bet on the future ahead, and longer-dated options cost more. So as a volatility bet rolls from one month to the next, the investor needs to pay up for the option for that next month in the near future. The cost of this roll is why betting on volatility is usually a losing bet (except in crises) and is usually used only as a hedge.
Investors bet against volatility in order to make money when the market isn’t volatile. Importantly, based on the nature of the options behind the VIX, investors also make money simply by betting against it, also known as shorting wherein you believe that a price will decline. (The risk is that things don’t go as you plan and the asset goes up in price rather than down. And when things go wrong when you’re short, things can go very wrong.)
Shorting volatility has a similar dynamic as shorting stocks with an important twist. Investors make money shorting volatility when either volatility declines over time and/or when the actual volatility is lower than was expected. As we described, the VIX is calculated using the expected volatility in the future. Since these expectations are priced to provide protection, they normally are priced with a bit of extra margin, which means the actual volatility is normally lower than the expected volatility. So every month as the reality catches up to the expectations, investors who are shorting the VIX make money. As long as things stay normal, this works like clockwork. Of course, things aren’t always normal.
And there are plenty of things that may not be normal in 2018.
The cause of the currently low volatility is hard to determine exactly but some of the reasons include:
- abnormally low interest rates,
- extraordinary asset purchases by central banks (a.k.a. quantitative easing),
- large share buybacks by corporations,
- the shift from active to passive investments,
- and steady and low inflation.
The result of these dynamics has been a market that has lulled investors into a sense of perpetual security or as Bank of America Merrill Lynch has described it, a bubble in apathy.
In 2018, we expect that bubble to deflate—if not burst—as central banks start increasing rates and selling assets and corporations slow their buybacks. There are also early signs of inflation that could become meaningful soon. If all of these things change slowly, then the market could react slowly and not be volatile. But history says that none of these things usually change slowly. No matter how much people want a soft landing, it rarely happens.
If the central banks can pull money from the market in a way that keeps the Goldilocks economy “just right,” the volatility market may be able to adjust gradually and everything will be just fine. But if history repeats itself and there are any shocks that spike volatility, then investors who are betting against volatility rising could lose their shorts.
The most transparent volatility investments are in exchange-traded products (ETPs). While volatility ETPs don’t own assets in the way that stock exchange-traded funds (ETFs) do, investors can trade them in the same way in any brokerage account. The two most popular volatility ETPs are the VXX, which attempts to mimic the VIX Index, and the XIV, which attempts to mimic the inverse of the VXX. These two ETPs allow you to either bet on volatility rising (through the VXX) or on volatility falling (through the XIV). Another way to think about these investments is that investors “buy” protection against volatility with the VXX and the VXX is a money-losing investment as long as volatility doesn’t go up. In contrast, investors “sell” protection against volatility with the XIV and the XIV is a money making investment as long as volatility doesn’t go up.
As you can imagine, the XIV has been a profitable and popular investment recently given the pervasive low volatility.
The risk for investors in the XIV is that a market shock could be a disaster. For instance, BofAML calculates that if the S&P fell by 5% in a day, the VIX could spike up by 10 points. The effect of that would be a 10x loss for investors in the XIV. Meaning, if you have $100 invested in the XIV, you would owe $1,000. As we said earlier, when things go wrong when you’re short, things can go very wrong.
Another popular trade has been to short the VXX. Combined, there is about $2 billion betting against volatility rising through both the XIV and the VXX. The direct losses from a 10-point move in the VIX would be $20 billion. But there’s also an unknown amount of leverage on these investments so that loss would likely be some multiple larger.
But that’s just the beginning.
Christopher Cole, at Artemis Capital, has attempted to count the total amount of investments betting against volatility. The issue is that most of these investments are in complicated and opaque strategies like commodity-trading advisor trend following, risk parity, and value at risk control. All told, Cole calculates that there is $1.4 trillion betting against volatility.
What would happen to that $1.4 trillion in a market shock? No one knows. Most volatility investments are tied to other investments so it’s not possible to pull on just one thread to understand the outcome if volatility spikes. But that’s also the scary part. For instance, if volatility spikes, investors who are short will want to buy volatility to close out their trade and limit losses. But those who sell their volatility investments may also want to sell their investments in the S&P 500 since those two investments are tied together. That could send the S&P 500 down further and that could send volatility up further. As Cole describes it, the snake may start eating its own tail.
The optimists in this debate will say that there are market structures that will prevent a runaway. And they’ll say that the volatility investments aren’t as large as those in the mortgage derivatives that brought down the market in 2008. And they’ll say that the trades being employed now and the AI trading systems being used today are much smarter than those in the past. That may be true but we think it’s always concerning when investors claim they have created a new no-lose investment strategy by layering complex math on top of complex math.
Investments using derivatives have been one of the more profitable inventions in the market. But they have also have a pretty high hit rate with major disasters. Volatility investing is essentially a derivative of a derivative. That could mean it is one of the greatest investment inventions ever. It could also mean it is a great disaster waiting to happen.
Ultimately, the issue is that measuring volatility is incredibly complex and investing in volatility could potentially create volatile results for the market as a whole.