There’s been a lot of focus on short vol strategies this week and many questions about how long it can continue. For those that are curious, below is a brief explainer on how short vol has contributed to the selloff.
In short, this episode is a textbook example of forced selling. It can be tough for investors to see markets and prices move so quickly and irrationally, but it also creates opportunity as forced selling means that price action disconnects from fundamentals.
- In this case, it was short vol positions that were crushed. Short positions started losing money because the VIX was ticking up. To limit losses, the shorts needed to go cover their short positions by buying VIX futures, which pushed those contracts and the underlying index even higher. This is called a short covering rally or a short squeeze. It is essentially buying that begets buying. Interestingly, in this case, the squeeze was in the VIX which moves inversely to the equity markets; thus, a rising VIX put downward pressure on the equity markets.
- A major method of shorting volatility was to short futures linked to a volatility index. Futures have embedded leverage because investors only need to post a fraction of the notional value as collateral. When the position starts losing money, brokers will make margin calls demanding more collateral. If the investor cannot post more collateral, they’ll have to close out their position or liquidate other portfolio assets. Thus, they either had to buy and push the VIX higher or sell other risk assets which pushed their prices lower. Either way, equity markets moved down.
- Once the troubled assets and players are identified, investors will begin pulling allocations. Exchanged-traded products, mutual funds, hedge funds, and so on will receive redemption requests. They will be forced to close out their short positions or liquidate other assets to meet redemptions. Again, this will further reinforce the price action.
Short covering, margin calls, and redemptions have exacerbated the recent market declines and they could continue. It is unclear how much exposure still needs to be unwound or what the leverage ratios are. Friday’s bounce may have been the bottom or there could be more pain to come this week. Investors should have a gameplan in place to take advantage of either scenario.