How to identify fatter tails and increased convexity

Posted by Michael Mescher on 17 May, 2017

Today we are witnessing the first spike in volatility in what feels like forever. For months, Gammon has been educating investors about the dynamics of volatility and how the vol market is evolving. We would like to use this opportunity to summarize these dynamics as they can be witnessed in real time today and are important for any institutions that travel in the vol markets.

Volatility is becoming a major asset class

Historically left to derivative specialists and institutional funds, the volatility market has become more accessible in recent years through the introduction of VIX ETPs such as VXX, XIV, and UVXY. These retail friendly ETPs augment the VIX options/futures market which is largely dominated by financial (although not necessarily volatility) professionals. Increased VIX trading volumes are fundamentally moving the CBOE’s earnings, and the broader market is becoming more familiar with the volatility space. A portfolio that does benefit from the convexity provided by VIX instruments has the potential to be improved on both a risk management and return basis.

More people are playing the short vol trade

As volatility becomes more main stream, the new market participants flock to the easiest trades. Historically in the volatility market, the “easy” trade has been short wing options, long XIV, or to play VIX roll down through futures. All of these are some form of short vol. Furthermore, with limited data (VXX wasn’t introduced until 2009 and it took the VIX futures market about 6 months to have any liquidity) many traders underestimate their downside risk of being short volatility/convexity. This also rings true for market participants with limited career history – enough time has passed that not everybody got to experience 2008 first hand.

Increased “dumb money” keeps implied vol artificially low

As the vol tourists bring excess supply to the market, volatility professionals are likely the marginal buyers. We saw evidence of this in the VIX settlement print today. VIX contracts/options settled at 12.98 despite the VIX trading at 12.00 seconds prior to the print. For the uninitiated, the settlement process is highly sophisticated and limited to industry professionals. The excess demand for volatility during the print is indicative of risk replacement by sophisticated market participants.

Volatility professionals will likely hedge their long vol daily (dynamic hedging) and in doing so will suppress realized volatility in the market. Supported by an already quiet market flooded with vol for sale, this dynamic creates a vicious cycle that entices less sophisticated participants to sell more volatility. All of this leads to increased convexity when volatility inevitably returns.

More vol tourists = fatter tails

This is the most important part. As we see people pile into the short vol trade seemingly unaware of its risk/reward proposition we anticipate a breakdown in the correlation between SP and volatility. This is due to increased convexity in the VIX ETPs as vol goes lower. This dynamic is not well understood by the market. While low volatility by itself can be a harbinger of increased convexity, the over levered positioning of market participants can significantly increase convexity. Currently, volatility has increased at a rate more than 2 standard deviations above the norm for typical market moves of this magnitude. If the VIX futures curve gets close to inverted, we would anticipate another scramble from short vol sellers to cover their positions. Understanding and hedging against these risks is paramount for anyone with exposure to volatility in their book.

A little over a week ago, we highlighted going outright long vol, unhedged. This is a deviation from our standard risk-parity approach. It has been difficult to carry, but given the risk/reward proposition, any other call would be difficult to justify. We commend those who took the opportunity to hedge their positions.