You can speculate on stocks going up or stocks going down, but you can also wager on how extreme the ups and downs will be. Investors who bet on calm have done stupendously well lately. As in a 180 percent return over the past year on the VelocityShares Daily Inverse VIX Short-Term exchange-traded note, which is one of the most popular vehicles for bettors on low volatility.
Trouble is, as the late economist Hyman Minsky observed, stability creates its own instability. People get overconfident in their investing savvy and overpay. Professional investors who thrive on volatility find it harder to make a living when markets are calm, so they invest with borrowed money to amplify their meager returns. That makes them as vulnerable to a price decline as any indebted homeowner; margin debt has grown as rapidly as stock prices since the 2009 market nadir.
The VIX, a gauge of expected stock market volatility, finished below 10 on only 26 trading days from 1990 through Aug. 2, 2017, and 17 of those placid days occurred since the start of May. The persistence of extreme calm may have pushed investors toward strategies that could blow up if volatility returns. “It’s not that volatility is low. It’s how long it’s been low,” says Ramon Verastegui, a managing director at Société Générale SA in New York. The bottom line is that highflying stock markets in the U.S. and other countries are more vulnerable to a big selloff than one would think from looking at the VIX alone.
The concept of the VIX is simple. It’s calculated from the prices of a range of options on the S&P 500-stock index. Options, which are a way to bet on stocks rising or falling to certain levels, go up in price when expected volatility is high. The reason: Big fluctuations in stocks make it more likely that the index will reach an investor’s target. The VIX is often called the “fear index” because it jumps when people fear a crash. They pay more for put options, the ones that make money if the S&P 500 falls.
The VIX has been a huge success for its sponsor, the Chicago Board Options Exchange, and has spawned products loosely based on it, including futures, options, and exchange-traded notes and funds. There are also volatility indexes on other markets in the U.S. and around the world and on individual stocks like Apple, IBM, and Google.
In July market plays based on the VIX accounted for 9 percent of the average daily trading volume of all exchange-traded funds and notes listed in the U.S., according to a calculation by Bloomberg. The iPath S&P 500 VIX Short-Term Futures note was the single most heavily traded exchange-traded product.
Since the VIX tends to rise when stocks fall, investors’ first thought—a natural one—was to buy VIX products as a hedge against losses on high stock prices. That turned out to be a bad idea. First, stocks didn’t fall. Second, VIX products are costly forms of insurance that end up dragging down returns in normal market conditions.
The new game is to go the opposite direction and bet on volatility’s staying low or even falling. That’s the concept behind the VelocityShares inverse VIX note, which trades on the Nasdaq like a stock with the ticker symbol XIV—or VIX spelled backward. It’s built on VIX futures contracts. An attraction for traders is that, because of the quirks of “rolling” old futures contracts into new ones, inverse notes tend to make money even if the actual VIX doesn’t go anywhere.
The effects of these complex new ways to bet on market behavior are unpredictable, but it’s easy to imagine how things could go bad. If the VIX rises because the stock market is dropping dramatically, investors who bet on a low or falling VIX must quickly find a way to offset their losses. One way to do that is to bet that the stock market will continue to fall. (Since stocks and the VIX tend to move in opposite directions, gains on their short position in stocks will offset losses from their VIX short.)
This is essentially how problems with the VIX could spill over into problems in the stock market itself. Selling could breed more selling, with few market players willing to take the other side. “We’re in completely uncharted territory. All these derivatives that have been built around the VIX didn’t exist in the past. We don’t know how much liquidity will be around them,” says Robert Hillman, chief investment officer of Neuron Advisers LLP, a quantitative asset manager based in London.
The question is what it would take to set off such a chain reaction, since none of the craziness of the past few years has done it. A flirtation with a U.S. government default in September, if Congress can’t agree to raise the debt ceiling, could do it. Raoul Pal, chief executive officer of Global Macro Investor, a monthly publication for hedge funds, says it would take more than that: a downturn in the U.S. economy that would drive down stocks and drive up the VIX further for longer. “If the market moves too far you get forced selling or put-buying,” he says.
The main reason to worry about the stock market isn’t the VIX, of course. It’s that stock valuations are historically high and dangers lurk, from the debt ceiling to North Korea. But the complacency reflected in the VIX tends to make those basic problems scarier. “The lower the level of the VIX, the more unstable the system becomes,” says Peter Tchir, head of macro strategy at Brean Capital LLC in New York. “When people look at whether equities are overbought or oversold, they’re ignoring this other element which is intimately intertwined.”
Volatility could rise abruptly if the “narrative” that investors tell themselves about the market changes, says Robert Shiller, the Nobel laureate economist at Yale. “Volatility is something economists will never understand because it reflects changing stories; it’s whatever occupies people’s attention,” he says. “It’s not a stable phenomenon.” Minsky would have agreed. —With Wendy Soong
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