By Charlie McElligott, managing director of cross-asset strategy at Nomura.
Fade to Black
The âgrey swanâ we all have spoken about for yearsâthat being the absurd âtail wagging the dogâ potential of VIX ETN market structure (inverse and leveraged products) AND the massive growth in ânegative convexityâ / âvol targetâ / âvol rebalancingâ strategies to either generate extra income or âsystematically allocate riskâ (looks good in the prospectus, right?!) âfinally âbrokeâ the volatility market, and has now bled-through to the âunderlyingâ spot equities marketâŚas the short vol trade went âlights out.âÂ
The ETNs are the âpatient zeroâ of this current market meltdown. It is estimated that there was anywhere from ~$125mm to $200mm of vega / VIX futs to BUY on the close from the two main âshort VIXâ ETNs that rebalance daily (XIV and SVXY). As S&P traded -50 handles AFTER the cash close from 4:00pm to 4:15pm into the marketâs anticipation of the massive rebalancing of volatility (buy to cover) on the close, XIV then saw a delayed and terrifying ~-87 PERCENT move after the close, as some who owned XIV puts as crash protection sniffed this potential and speculated liquidation from the ETN, which is set per a rules-based system to buy back short vega after an 80% âcrash triggerâ(which again isnât a certainty because they use a blend of 1st and 2nd month). The asset pool nonetheless was seemingly / largely wiped-out and the note is guaranteed to âpay outâ to their shareholders as set per their prospectus. It is likely that this thing has indeed been âtriggeredâ and will be forced to liquidate. SVXY doesnât have the firm 80% âtriggerâ but too is seeing its NAV âwiped outâ and is trading ~-80% post-close as well.
The issue NOW is the pile-on going-forward across assets, as the systematic âshort volâ communityâs models are now completely toast, and they too will be forced to cover remaining âshort volâ positions that didnât trade todayâi.e. BE PREPARED FOR A MAJOR VIX FOLLOW-THROUGH TOMORROW.Â
VaR-based models need to be reset across all asset-class strategies, forcing further de-risking over the coming days and potentially weeks, as heads of funds and heads of risk try to figure out how much their models are forcing them to âgross-down.â Shorter-term vol target / vol allocation strategies (think CTAs) and longer-term models like risk-parity and too will reset and ârebalanceâ their risk (lower) as realized vols are re-priced. Structured products, annuities and other vehicles with built-in protection? Also purging exposure on the vol reset. Finally, it also shouldnât be lost on the popularity of âshort VIXâ trades in the retail community, and the âbutterfly flapping its wingsâ relationship to the recent melt-down in the crypto-currency space.
The âwhite knightâ of corporate buybacks (which by the way were running at 300% of volume today per a competitor as they were pumping the mandates to hold-up their stocks) will be extraordinarily tested with keeping the stock-market âpropped up,â especially as the traditional active community is likely to back-away until there is a better sense on how this event shakes out⌠few will willingly be in there tomorrow prepared to catch this falling knife.
Cross-asset, the trickle-down of unwinds is clearly a focal point from here. As noted two weeks back in the âNomura Cross-Assetâ piece, Iâve been focusing on the âriskâ of positioning asymmetries with consensual âbearish ratesâ / âflattenerâ and âshort USDâ trades primarily, but too, crowded thematic equities position tied to the rates and USD trades (i.e. âlong momentumâ / âlong tech / growthâ).
As such, the +7 Z-SCORE (relative to 90d move) today in the UST 2Y/ mongo bull-steepening seen in 5s30s (+7bps today, +17bps since Thursday) raises a âpain tradeâ red flag. Single-stock equities clearly took a hit on the back of the index moves, as thematic trades like âlong US high betaâ--which was +8.1% YTD on Jan 26thâare now -1.5% YTD after trading down -7.1% the past two sessions alone. The six-day move in US momentum longs has been -4 standard deviations (across all returns dating back to April â13), only previously experienced during the âFlash Crash.âÂ
My model equity L/S portfolio experienced its worst day since the early Feb â16 market-neutral unwind which occurred during the âgreat deflation scare.â Net / net, it wasnât pretty out there.
Buckle-up, because this move isnât over yet.