When the Chicago Board Options Exchange sat down with Goldman Sachs traders in 2003, it would prove to be one of the most profitable meetings in the exchange’s history.
It set in motion the creation of a wave of financial products built around the concept of trading volatility in markets. The appeal of betting on whether equity markets will remain calm has sharpened in recent years as historic bond-buying programmes by central banks have repressed volatility across equities and debt.
Now, as robust economic growth convinces central banks to reduce their support for asset prices, the sheer scale of the volatility-trading ecosystem that has ballooned is worrying some investors and analysts who believe that this week’s turmoil is merely the first instalment of a shock for global markets.
The traders at Goldman Sachs pitched to executives at the Chicago-based Cboe a futures contract based on the exchange’s Vix volatility index, a measure of expected market volatility based on options written on the S&P 500 that was first introduced in 1993.
Given its tendency to rise when stock markets rapidly fall, the index was quickly given the moniker of Wall Street’s “fear index”, a name that even inspired a thriller by Robert Harris, and has minted Cboe a fortune.
Sandy Rattray, now chief investment officer at London-based Man Group, was one of the Goldman traders who, with his then colleague Devesh Shah, helped devise a complex formula that synthesised thousands of different options trades into a single tradable number for the futures contract.
The development of Vix futures has opened the door to an array of exchange traded funds (ETFs) and notes (ETNs) that allow institutional and retail investors to buy and sell equity volatility.
Such an outcome appals Mr Rattray. “We modelled what an ETF would look like, talked to a large ETF provider, and we looked at what performance would look like,” he says. “The performance was so poor we concluded we shouldn’t show a product like that to investors.”
For some such products, their demise on Monday came quickly. In a matter of hours on Monday as the level of Vix — having slumbered below its long-term average of 20 for months — rocketed to briefly touch 50 and the S&P 500 endured its biggest one-day drop since 2011.
As the S&P tumbled, the crowded “shorting volatility” trade, in which ETPs sold Vix futures, unravelled, pushing Credit Suisse and Nomura to pull the plug on two funds, while others were left a shadow of their former selves.
The scale of the returns the trade offered dulled the risks. Buying the largest short volatility ETP — run by Credit Suisse and known by the ticker XIV — at the start of 2015 and holding it to the end of 2017 generated a return of 320 per cent. Holding it from the start of 2015 to after Monday’s eruption, resulted in a total loss of 85 per cent.
“It became this very complacent trade,” says Peter Tchir, chief macro strategist at Academy Securities.
But XIV was just one part of a vibrant, if controversial, corner of the market for trading volatility. There are about 40 Vix-linked ETPs, according to Goldman Sachs, and most allow investors to bet on volatility rising. The costs of these funds tend to burn through investor money, keeping the Vix ETP industry’s assets capped. However, many have become popular, ranking among the most frequently traded exchange products, and rivalling the stocks of companies such as General Electric.
“Volatility has become both an input for risk-taking, and something you can trade,” says Christopher Cole of Artemis Capital Management. “Volatility has become a player on the field.”
In turn, the behaviour of the ETPs has helped fuel the Vix contracts that form their basis. So much so that it has led to concern that the financial products built to make money from tracking the Vix are now feeding back into the ingredients from which Vix is calculated.
Traders say that at the end of Monday, the ETPs that ran into trouble from an initial rise in Vix scrambled to cover positions by buying large amounts of Vix futures, sending the price of the contracts soaring. The Vix, in turn, rose further and the S&P 500 sank.
The mayhem has not spared the Cboe, with the exchange’s share price falling by as much as 28 per cent this week. Vix futures were responsible for about 40 per cent of the exchange’s earnings growth between 2015 and 2017, according to Goldman Sachs, with ETPs accounting for roughly 20-30 per cent of the “open interest” in Vix futures in recent years.
Edward Tilly, the exchange’s chairman and chief executive, sought to quell concerns on Wednesday by saying on a conference call that “Vix can’t create volatility”. Cboe says it does not expect any significant fallout from this week’s events.
They may yet be right.
This week’s turmoil has honed the lustre of the long-Vix ETPs, or those that profit from higher volatility and, even for the short-Vix products that are left, inflows have resumed — albeit gingerly. The Vix remains elevated and derivatives analysts say this may indeed be an attractive time to bet on some semblance of calm returning to markets.
A bigger concern, however, is that Vix ETPs are merely what we know of the bigger volatility-trading universe that has grown over the past decade. And the ructions caused this week highlight how even small moves can cause tumult in financial markets even when the economic backdrop is favourable.
“These funds are just the tip of the iceberg,” says Jeff Shen, co-head of BlackRock’s Systematic Active Equities business. “This gave us a potent example of what a potential turning point (for markets) will look like.”
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