(Bloomberg) -- Among the many scary things traders witnessed as stocks plunged last Monday, one of the most harrowing was the sight of the VIX, an index designed to measure investor fear, briefly going dark.
For almost 30 minutes as hundreds of billions of dollars were erased from equities, no signals were sent by the world’s most popular sentiment gauge as options prices turned erratic. When it switched on, the VIX jerked higher faster than anyone had ever seen, rising 82% on its first tick to 51, a level not reached since the financial crisis.
“Seeing the VIX at 50 was just chaotic,” says Michael Antonelli, an institutional equity sales trader and managing director at Robert W. Baird in Milwaukee. “It’s not like there was a headline that a bank had filed for bankruptcy or a major corporation was teetering on the brink. Why did it move that much?”
Nothing could’ve kept the Chicago Board Options Exchange Volatility Index from jumping Monday morning: global markets were buckling, China’s stocks had plunged 8% and companies like General Electric were in free fall. And nobody’s saying the VIX broke or acted in a way that wasn’t predictable, given the array of forces that act in the markets it reflects.
According to options traders and analysts, though, a wild ride was made even wilder by pressure flowing from a network of interconnected volatility markets, some of which barely existed as recently as five years ago.
According to its overseer, CBOE Holdings Inc., it was simply fear in the market that drove the surge, reflected through higher prices in S&P 500's Index options, especially as stock futures reached daily limits.
“I’m not sure that the VIX at 50 was completely outrageous,” says Bill Speth, vice president of research at CBOE. “Market makers or people who trade S&P 500 options are going to demand far much higher for that protection when the market is down 1,000 points.”
Derived from the price of options on the S&P 500 and the benchmark for a hodgepodge of futures and derivatives, the VIX is a tool for professionals and amateurs alike to measure nervousness in equities. Its basic ingredients are puts and calls on the S&P 500, which appreciate in value when fear is in the air. Stocks gyrate and the VIX rises, the result of dealers charging more to bet on price swings.
The VIX is also an asset unto itself, with futures tied to its price traded virtually around the clock by hedge funds and other speculators. Those contracts are, in turn, the basis for some of the most heavily traded exchange-traded products in America, things like the iPath S&P 500 VIX Short-Term Futures ETN. Once obscure, now they’re huge, with combined volume in the hundreds of millions of shares each day.
Why would anyone need to own such things? To hedge, primarily. If you’re worried stocks will plunge, buy a VIX future or ETP, whose price goes up as turbulence intensifies. On Monday morning, turbulence was intensifying. Equities around the world were down 5% or more as orders piled up in the U.S. market to sell.
“As U.S. traders were hitting their desks, they were probably taking a shot going long volatility,” says Yousef Abbasi, the global market strategist at JonesTrading Institutional Services in New York. “Volatility has been so cheap for so long that a lot of people have potentially been waiting for that spike to happen. They saw that opportunity and boom, there it was.”
What ensued, traders and analysts said, was a snowball effect, a feedback loop in volatility derivatives worsened by diminishing liquidity and an options expiration the prior week. The tumble in S&P 500 futures, which reached the 5% daily limit just before exchanges opened, wreaked havoc on options prices, pushing spreads as much as 16 times wider than normal.
Besides the VIX going dark, the most visible manifestation of the deluge was volume in futures tied to the VIX. In the hour before the market opened Monday, traders exchanged 78,000 of the September contracts, more than four times the average at that time in the 20 days prior, Bloomberg data show.
Traders were nervous, naturally. Some had to cover short positions in VIX futures, essentially bets on a rising stock market that had worked for years. Hedge-fund managers were net long more than 16,000 of these VIX contracts through Tuesday, as opposed to a net short 55,000 positions on Aug. 18, according to U.S. Commodity Futures Trading Commission data.
Another reason, analysts and traders said, was a crush of buying in volatility exchange-traded notes and funds, which buy VIX futures to keep up with demand. Shares outstanding in the notes overseen by iPath and two others reached a record Friday as $1.5 billion of fresh cash flowed into the products this year.
In all, volatility ETPs hold $4.3 billion in assets, according to Bloomberg data. About $12 billion in shares were traded on Monday, the highest daily value on record, the data show.
“These products do drive up volatility of volatility, and they did help volatility reach higher peaks this time around,” says Rocky Fishman, an equity derivatives strategist at Deutsche Bank AG. “When volatility is going up, they buy more VIX futures, which ups volatility more. We have seen a large re-balancing in those volatility products over the last few days.”
Volatility has hovered around historically low levels over the past few years, which shows surging VIX futures demand hasn’t swayed the gauge, the CBOE’s Speth said. Up until August, the VIX averaged 15 on a closing basis this year, five points below its all-time average of 20.
“The idea that VIX futures are driving volatility in the market just seems unlikely to me,” Speth says. “Yes, we traded a lot of VIX futures on Monday, but it was in response to market moves. It didn’t cause market moves.”
Another factor: options listed in the U.S. on securities from the S&P 500 to single stocks expired Aug. 21. That means any outstanding monthly options set to expire this month were swapped for shares, causing the contracts’ holders to adjust their portfolios accordingly.
As traders watched stock-index futures tumble Friday morning, they played catch-up by selling more equity futures and buying up futures on the VIX into the open. These speculators also rushed to add S&P 500 options in lower strike prices, according to Scott Fullman at Revere Securities.
“People were hedging as the market was coming down and that was exacerbated by expiration on Friday,” says Fullman, managing director and chief strategist at Revere Securities in New York. He publishes options market analysis. “It turned around and cascaded into other products in sectors and inversed and leveraged products. You had all of this happening at one time.”
Tightening regulations that have crimped the market-making role of big U.S. banks in options trading could have added to the quick run-up in options prices. Much of the Volcker Rule, a 2010 regulation that restricts banks’ ability to trade with their own money, came into force July 21.
“We’re seeing the results of the reduction in liquidity on the hedging side through the VIX significantly outpacing the equity market,” says Justin Golden, a New York-based partner at Lake Hill Capital Management. His firm trades options on equity indexes and commodities. “Everyone who needs to hedge will trade or buy options at any price, but the supply side of hedging has been significantly reduced.”
It took about an hour for markets to level out after the deluge of selling. By 10:30, the S&P 500 had gained back more than half its losses, eventually closing down 3.9%. The VIX pared its jump to a 45% gain, almost equivalent to its 46% rise the previous Friday.
Since last Monday, the volatility gauge has dropped another 36% as American equities have rallied back 5%. While most of the VIX’s jump has been erased, the memory of the event remains.
“We haven’t seen an explosion of volatility like that in a while,” said Dan Deming, a Chicago-based manager at KKM Financial. Deming was a trader on the CBOE floor for 26 years. “It was a significant day. Days like that have lasting repercussions. It cracked the foundation of the stock market.”