With the VIX soaring, from single digits yesterday to over 15, risk is suddenly breaking out above the crucial Kolanovic redline level…
And Nasdaq is tumbling.
… it is worth reminding readers just how coiled the short-vol sector is, something we described two weeks ago in “If The VIX Goes Bananas” This Is What It Will Look Like” and in which a Morgan Stanley trader detailed how a devastating short vol unwind might develop:
A violent rise in volatility could be driven by just a 3% to 4% one-day S&P 500 selloff. Right now the risk is greatest in the VIX complex, and demand for VIX futures from three main sources could result in 100,000 contracts ($100mm vega) to buy in a down 3.5% SPX move. For context VIX futures ADV over the last year is 230,000 (although has risen to as high as 700,000 in big selloffs).
As MS’ Chris Metli further explained, should the S&P fall 3.5%, “first, the VIX could rise as much as 12 points. When volatility is low it tends to move a lot for a given change in the S&P 500. That effect is likely to be exacerbated now because a) skew is steep (and VIX rolls up the skew in a selloff) and b) many players in the VIX market are short. Taking these dynamics into account QDS estimates VIX could rise ~12 points for a 3.5% 1-day decline in SPX.”
He also notes that If the VIX rises 12 points, 1-month VIX futures are likely up 5.5 points, a ~50% increase. The 1-day percentage change is a big deal in the VIX complex because the levered and inverse VIX ETFs and ETNs rebalance daily based on the percentage change, and some of the thresholds for forced unwinds are based on the percentage change.
This is the forced deleveraging scenario, where surging VIX forces vol sellers to unwind, and buy more VIX, creating a feedback loop, that Jeff Gundlach envisioned earlier this week.
As we noted yesterday, there has never been more trades placed on VIX.
And short volatility bets have never ben higher.
And just to get a sense of how massive the potential unwind could be, here is some additional data from JPM which reminds us that the Vega of VIX related ETFs adjusted by short interest has never been higher.
in Figure 4 which is provided by our Equity Derivatives Strategy team and which uses a more sophisticated calculation to estimate the net vega, i.e. sensitivity to each percentage point change in vol, for the total universe of VIX related ETFs adjusted by their short interest. This vega stands at historical high levels currently.
This means that once the VIX buying cascade begins in earnest, stopping out thousands of vol-sellers, nobody really knows when and how it will end.
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