Last Wednesday saw a huge increase, in percentage terms, of the volatility indices. The 1M spot VIX increased by 46%, while the underlying SPX index decreased by only -1.8%. As discussed in our previous post entitled Is Volatility of Volatility Increasing?, such a big percentage change in the VIX associated with a “normal” down day is rare. It happened only 0.16% of the time since 1990.
Consistent with our observation, Dana Lyons also pointed out that such a change in volatility was outside of the normal range:
Wednesday saw the single largest daily spike in the history of the VXST. But even that is understating things. The VXST actually more than doubled on Wednesday, rising 125% from 8.96 to 20.17. The spike was nearly 50% larger than even the previous record (8/21/2015). Read more
But we ask ourselves again the question: what caused such a big change in volatility?
While it will take a long time to arrive at satisfactory answers, we have found explanations provided by Deutsche Bank analysts, as reported by Tracy Alloway of Bloomberg, plausible:
Large dealer banks that buy or sell the S&P 500 to hedge exposure to U.S. equities are helping to suppress realized volatility and keep the VIX low, the Deutsche Bank analysts say. By their estimates, dealers would have to buy $14 billion if the S&P 500 fell by 1 percent. It’s all about “gamma” — the third Greek letter.
“When dealers are long gamma they sell equities when equities are rising, but buy them when they’re falling,” write Deutsche Bank analysts led by Rocky Fishman. “The primary reason” for the VIX index being so low is the multi-decade low in fluctuations in the market itself, according to the team. And the long gamma positions of dealers “is a contributing factor to the ongoing low-realized vol,” they wrote.
The above explains why the volatility is usually low these days. This is consistent with an explanation we provided earlier in the post entitled Why is Volatility so Low?
However, in time of panic, the volatility can increase very quickly due to short covering and rebalancing of VIX ETNs:
While the hedging needs of big banks have helped keep a lid on volatility by providing a backstop to moves in U.S. equities, the analysts note, the rebalancing requirements of the plethora of exchange-traded products now tied to the VIX could pose a risk to that stability. Such ETPs typically buy VIX futures as the underlying index rises, and sell futures as it declines, creating a so-called ‘short gamma’ position.”
If the VIX were to spike, then Deutsche Bank calculates those ETPs would have to buy a record amount of “vega” — meaning they’d have to put on trades to bet that volatility will increase. “Vega to hedge on a spike has continued its steady rise since the vol increase around U.S. elections, and sits close to $90 million,” a record, they said. Read more
It is difficult to estimate the impact of VIX ETNs on the markets going forward. As always, a solid risk management plan is in order.