An old colleague, when asked how he was doing, would always reply “like a Duck”. No, he hadn’t taken to squawking when around bread, but rather that he looked serene on top, but propelled by panicked flapping underneath. The market is currently similar. Although many prices of many assets are within the year’s ranges, and implied volatility measures have been falling, there is the sign of a flapping webbed foot or two emerging in the gloom.

Let’s look at our favourite cross asset chart:

This was normalised as of the lowest levels of vol in the summer of 2014. It’s been noticeable since the Trump election that FX and rates vol has stayed elevated as equity vol has fallen. But not in the last week or so. Those lines at the bottom are coming right back at ya. Various reasons have been given, not least that with the VIX around decade lows, it was cheap for a bit of France Presidential Election wobbling. Or for a Russia/US war. Or for a US/China war. Or indeed any other wars that may now be looming after the President changed his mind on Syria due to Ivanka’s (frankly understandable) upsetment. [Along with the market realising that “Republican Clean Sweep” doesn’t mean “President can do whatever he wants”, they need to wake up and realise that the White House staff is very much prone to change in terms of who is the influencer].

Those are genuine risks and should be on every investor’s radar. But these kinds of moves in the VIX may be symptomatic of something else: positioning. When all else falls quiet, that’s when we can shine a light on the tiny exit doors for markets where positioning becomes too big. There is still a large short position in US rates: the US 10yr yield is therefore still vulnerable to a wobble. But let’s take a look instead at another important market that has grown in size – the VIX.

[The following charts are provided by Variant Perception, an American investment analysis firm who produced this interesting paper on the nature of volatility.]

So during the period where the VIX has been a significant input into everyone’s risk management process, it has itself become a much more highly traded asset. This matters, because it affects its price. As VP explain [emphasis my own]:

We can convert the AUM of these ETFs into a USD vega equivalent after adjusting for leverage and short interest. As we can see from the left chart below, the vega from these ETFs is often worth 30-40% of the entire open interest in the futures market, making them a very significant driver of volatility at present.

 The right chart shows the impact of the ETFs on the VIX futures term structure. ETFs have to constantly roll their VIX futures positions from the front month to the second month (the two most liquid contracts). Therefore, when ETFs are very long volatility, they exert steepening pressure on the VIX futures curve, as they keep selling the front month contracts to buy the next month ones. Similarly when the ETFs are net short volatility, they exert flattening pressure.

This is all very obvious to volatility traders, and may already be obvious to you. It sounds very similar to the kind of delta hedging that goes on in options land. It might just remain a footnote in the dark netherworld, except that when the world goes a bit quiet, such as, say, over an Easter holiday, it could have a much bigger impact.  That second chart, of the VIX Futures premium, now looks – crudely – more like this:

This significant flattening in the curve suggests that the overall VIX market is short vol. That would make sense – after all, selling vol has been the winning strategy for the past 5 years or so:

Again, that makes sense, because central banks’ massive interventions worked deliberately to pump up our depressed deflationary animal spirits. They wanted a world of no volatility. After all, 2008 had quite enough to last us a lifetime. The trouble is, the period of no vol has also lasted a lifetime. The emergency turned into the norm. Selling vol became a strategy in itself. Usually, that’s fine. One day the world changes, the strategy stops working, and the world moves on. Creative destruction.

But what if an entire strategy were devoted to an asset that itself was an input to a whole bunch of other strategies?

What if the world used that asset as a kind of measure of the world’s Fear?

What if that asset suddenly had no price? What would the world think then?

If this sounds like crazy talk, let’s go back to August 24th 2015. The day when we had a sudden 1,000 pt drop in the Dow and it was a kind of mad summertime flash crash in all of the world’s markets. Let’s just see what happened to the VIX back then:

Prices for the CBOE Volatility Index, the market’s favored barometer of volatility, did not update for the first half hour of the trading, a result of market volatility that also led to erratic quotes in S&P 500 options, Suzanne Cosgrove, a spokeswoman for the CBOE said.

Traders who wanted to buy and sell SPX options were held back because a lack of liquidity caused problems in their pricing. Many were at zero or had bid/ask spreads so wide that they were unusable for trading. As a result, SPX options barely traded.

“Basically, the computer market makers that sit behind it all were flashing ‘I don’t want to trade’ signs,” said Jim Strugger, a derivatives strategist at MKM Partners.

The lack of liquidity was not restricted to SPX options, but was broad based, with even normally very liquid sector Exchange Traded Funds (ETFs) hardly trading in the first hour or so, strategists said.

“It was extremely difficult to put any trades on in options,” said Steven Spencer, partner at proprietary trading firm SMB Capital in New York. “There were no offers in a lot of options that we were short, so we couldn’t cover anything.”

However, the market righted itself by 10:30 a.m., Spencer said.

When the volatility index did start updating, it quickly shot up to up 25 points to 53.29, the highest since Jan 2009.

While options volume was robust later in the day, with trading volume of about 31.5 million contracts, nearly 75 percent higher than what is normal, the lack of liquidity in the first hour is likely to raise eyebrows.

“There is no doubt that people are going to look back instantaneously and start evaluating liquidity just as they did after May 2010,” said Jim Strugger, a derivatives strategist at MKM Partners.

Oh Jim, if only we had. But we haven’t. And the difference now is that there is an awful lot more risk out there on the table. August 2015 didn’t have Trump or Brexit or Le Pen or a new Cold War or indeed, anything much except for some worries about China.

Just remember the Duck and ask yourself: At what point does the frenzied paddling up-end all the calm serenity?

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