The “Nightmare Scenario”: Quantifying The Damage From A Sudden VIX Spike

Thursday, July 20, 2017
By Paul Martin

By Francesco Filia of Fasanara Capital
ZeroHedge.com
Jul 20, 2017

How Bad a Damage If Volatility Rises: The Bear Trap of Short Vol ETFs

As if there was any need for any more threats to financial stability in a world overburdened with debt facing rising interest rates on bubble valuations in both bonds and equities, within an environment dominated by economic policy shifts and political gridlock, there is a potential bear trap right in today’s most fashionable investment products, which risks deflating fast: Short Vol Exchange-Traded Notes and, more broadly, volatility-driven investment vehicles. In this note we will discuss briefly the former. A full analysis and access to our data room is available upon request.

Years of Central Banks’ hyper-activism, financial repression and regular bail-out of financial assets led to a collapse in volatility, and the ensuing investment mania in volatility-driven strategies: risk parity funds in primis, vol-levers of all types, but also exchange-traded notes directly linked to volatility. Among these, Short Vol ETFs have grown relentlessly, oftentimes including leveraged plays, oftentimes sold to retail, fully or partially un-aware of how quick wipe-out-type risks can materialize on such products, and how close we got to such wipe-out risks. For the purposes of our scenario analysis, we will define a wipe-out risk as one of losing more than 75% of the original investment.

We find that the total size for vol-linked ETFs, after leverage and Beta-adjusted is almost $40bn.

The conventional wisdom goes that VIX has never historically moved up so much and for so long as to wipe-out short vol strategies. It would typically require a doubling up of VIX in short order, which has never occurred on a daily basis across modern history.

However, as VIX drags itself around rock-bottom historical levels, often at sub 10-levels, while equity valuations are the highest in history, the risk of volatility doubling up is today materially higher than it has ever been. If VIX was at 20, to double up it would have to move to 40: a statistical outlier. But VIX trades around 9/10 now, from where doubling up simply takes it to 18/20 territory, which is actually spot on the average for VIX on recorded history since 1993 (while median is 15.95). VIX was actually higher than that 30% of the times. If and when it happens, such ETFs would suffer dramatic losses. For wider moves than that, some of the volatility-linked instruments would be almost wiped-out. In others, where a short-vol position can easily be extracted by shorting a leveraged long-vol exchange-traded note, the investor would stand to lose up to 650% of the capital invested.

The Rest…HERE

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