Monday, February 5, 2018, was a brutal day on Wall Street. The Dow Jones Industrial Average saw its largest point drop in history, closing down 1,175 points. The unprecedented decline also rocked other market measures, most notably the CBOE Volatility Index, commonly known as the VIX. The VIX, which measures how calm or nervous investors are, experienced its largest spike in history, rising 116 percent on February 5. Its previous record was just 64 percent.
This spike in volatility made the pullback worse than it might otherwise have been, but by an indirect route. First, we need to understand that on Wall Street, if you can measure it, you can invest in it. In recent years, a number of products have been created to provide investors with exposure to volatility by investing in VIX futures contracts. In fact, at last count, there were 24 exchange-traded products (ETPs) that invest in VIX futures contracts in some fashion—some are long volatility, some are short, and some even provide leveraged exposure to VIX futures. Some of these products have (or had) billions of dollars in assets.
These products have legitimate uses. Many investors, for example, use long VIX ETPs as a hedge in case markets drop, since they are supposed to go up. On the flip side, though, some investors have been seeking to take advantage of the steady rise in the markets and low volatility throughout most of the past two years by investing in short volatility products.
Assets in inverse volatility products appreciated dramatically in 2017—with some up as much as 180 percent for the year and others providing a five-year annualized return of more than 50 percent! As investors chased this performance, assets in short volatility products ballooned to $4 billion. And that was the problem.
On February 5, when the VIX spiked late in the afternoon, the sponsors of these short volatility products scrambled to cover their exposure, while other related products were also forced to respond. In order to rebalance their portfolios to track their underlying indices, these sponsors had to buy, by some estimates, approximately 230,000 VIX futures contracts at the end of the day on February 5. This surge in demand, coupled with limited supply, pushed up the price of VIX futures drastically, resulting in the 116-percent spike in the VIX. This, in turn, led to an average price decline of 96.1 percent for the two major short volatility products. But, more important, it also rattled financial markets.
Since the VIX is a major indicator of market fear, that spike appears to have led other investors and traders to react by selling, which worsened the decline. What was a technical issue, confined to a couple of products trading in derivatives, turned into a significant contributor to the market decline. This is a good example of how one aspect of the markets can affect others.
Since then, of course, as the volatility trades have normalized, so has the VIX—and so have markets in general. Fortunately, this type of volatility effect should not be a problem in the future. As it stands now, one of the two products responsible is being liquidated, while the other is now less than 1 percent of the market, so it will no longer be a risk factor. Is another volatility spike possible? Sure, but we should not see these VIX ETPs negatively affect the market as they did early this month.