It was widely reported on Wednesday that a trading desk at Goldman Sachs (GS - Free Report) had made a profit of $200 million dollars in a single day trading the CBOE Volatility Index.
Goldman is reported to have been long the index on February 5th, a day the S&P 500 sank more than 4% and the VIX more than doubled. Though it was not disclosed exactly which instruments the firm was trading, in the wake of the news, this seems like an appropriate time to examine how the VIX works, who trades it and why, and how an individual investor might take advantage of opportunities in VIX options.
The Chicago Board Options Exchange - now CBOE Global Markets (CBOE - Free Report) - introduced the VIX index in 1993 as a single number that would allow traders and the investing public to know the level of implied volatility in options on the broad markets. The original VIX was calculated from 8 front-month options on the OEX (the CBOE’s index on the S&P 100.) Historical values going back several years were also made available at that time.
In 2003, the calculation of the VIX was modified to use the more liquid options on the S&P 500 - the SPX - and the basket of options in the calculation was expanded to a weighted average of all the at-the money and out-of-the-money options in the front two months with an average of 30 days to expiration. The intention was to make the index a more representative sample of the option market’s prediction of future volatility.
In 2004, the CBOE introduced futures contracts on the VIX. Because no physical commodity or instrument can be exchanged, VIX futures are cash settled, with the two counter-parties to a trade exchanging the cash value of the difference between the traded price and the settlement price of the index at expiration.
In 2006, the CBOE first listed options on the VIX. Like the VIX futures, the options are cash settled with the difference between the settlement price and the strike price of in the money options exchanged. Other than the fact that they are cash-settled and are European exercise (they cannot be exercised prior to expiration - which is a basically inconsequential detail to most individual investors) they trade just like options on individual stocks.
Several ETFs have subsequently been introduced that allow traders to gain long or short exposure to the VIX, including some that are double or triple leveraged.
For reference, the highest value ever recorded in the VIX intraday is 89.53% and the highest close is 80.86%, both occurring during the financial crisis of 2008. The all-time intraday low is 8.56%, and the lowest close ever is 9.14%, both occurring in late 2017.
The long-term average price of the VIX is slightly less than 19.9%. The average over the past few years has been closer to 12%, but with a few huge spikes.
Although it is commonly referred to as the market’s “fear gauge”, high VIX values could actually mean an expectation of a large move in either direction, but because of the well-documented belief that markets fall faster in bad times than they rise in good times, the VIX tends to increase most in times of market panic when stock prices are moving down.
VIX Futures Prices
The VIX futures are almost always higher than the cash VIX value in a price relationship known as contango. As the expiration of a futures contract nears, the price of the futures steadily converges with the cash (or “spot”) price of the index. At expiration, the settlement price used is the cash price.
In quiet and steadily rising markets - like we saw between 2016 and February of 2018 - this contango relationship creates an opportunity to make easy profits selling VIX futures. Because observed volatility was very low during this period and the VIX mostly stayed in the low teens, traders could make money by selling VIX futures and simply waiting for them to converge with the (lower) cash VIX price. In many cases, instead of selling the actual futures, traders purchased the XIV, an ETF that replicated a short position in near term futures - except with 2X leverage.
There are several factors that contributed to the extremely low volatility experienced during this period, but it is widely agreed that a major factor was the growing propensity of individual investors to eschew actively managed funds and instead pour their money into broad-based index funds. Consistent inflows into a diverse basket of stocks tends to dampen the price volatility of the basket.
Look Out for the Steamroller
With the benefit of hindsight, we can see how this trade ultimately turned out. Selling VIX futures turned out to be what is commonly known in the industry as “picking up nickels in front of a steamroller,” meaning taking a succession of small profits, while ignoring the probability of an out-sized loss that wipes out all of the accumulated profits and potentially much more.
Why would a trader take risks that eclipsed the potential rewards?
There are two main reasons. One is that the trader is ignorant of the risk - or at least vastly underestimates it.
The other possible reason is that the trader does understand the risk, but because of a contractual arrangement with either investors (in the case of a hedge fund manager) or the trader’s employer (in the case of a firm proprietary trader) it is in the trader’s immediate best interest to book easy profits while taking outsized risk - because he will be paid a portion of the profits if the trade works, but is not made to personally bear a share of the losses if it doesn’t.
Hint: In the long run, it’s profitable to be on the other side of the trades of either of those traders.
In an August 2017 article on the growing popularity of leveraged VIX and inverse VIX ETF products despite the risks, the New York Times profiled a trader who had quit his job as a manager at a Target store to sell the VIX full time. He claimed to have started with $500K and grew the account to $12 million over the preceding few years.
When the Times interviewed that trader again, one day after the VIX experienced its biggest single-day spike ever (on February 5th, the same day Goldman Sachs took in that $200M haul), he admitted to feeling pain in the trade, but said he was still betting 21% of his portfolio – or $600,000 – in continuing to sell the VIX. If 21% of his portfolio was then worth $600K, some quick math would suggest that he had already lost $9 million - a 75% drawdown.
The double short XIV ETF was closed down completely in February by the issuer after losing over 80% of its value in a short period of time. Many traders who were short the VIX faced margin calls and had to either post additional capital to maintain their accounts, or have their trades liquidated at steep losses.
Online broker Charles Schwab (SCHW - Free Report) reported a $15M non-recurring charge in the first quarter of 2018 to cover the negative account values of customers who were selling VIX products and suffered losses in excess of funds on deposit.
Profit and Protection
Even if you buy the premise that selling VIX instruments for short term profits is ultimately a losing trade, doing the opposite can be painful in a different way. Investors who own VIX futures or ETFs tend to suffer constant losses for months or even years before experiencing an increased volatility event that makes the trade profitable.
Admittedly, this can be an emotionally difficult way to trade.
When considered as a hedge against a diversified portfolio of equities however, owning calls on the VIX starts to look like a wise decision. Though they are likely to decline in value during steadily rising markets, those options will rise significantly in value at exactly the times during which the broad markets are experiencing the most difficulty.
Goldman Sachs had the prescience and discipline to stay long fairly inexpensive VIX instruments in order to be able to sell them out at hugely profitable prices when the rest of the market needed them most.
In the end, the decision come down to a simple question. Do you want to be positioned like Goldman - one of the most sophisticated and successful firms on the street, or do you want to be positioned like a short-sighted day trader who will soon be looking for a new day job?
Owning VIX calls is a fairly simple way for an individual investor to protect gains in the equity markets, knowing that the long term odds of success are on your side.
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