Why Did XIV Collapse & VIX Spike When S&P Dropped Just 4%?

There been a great deal of attention, and rightfully so, to what’s being dubbed ‘Black Volatility Monday’ with the demise of the short volatility ETN (XIV) and the massive spike in the Volatility Index. Kid Dynamite did a nice job outlining one likely reason for XIV’s implosion.

Another view that I think is worth reviewing that also takes a look at how/why the VIX rose by such a magnitude when the S&P 500 only declined by 4% is by Artur Sepp, a Quantitative Strategist for wealth management firm, Julius Baer in Switzerland. Sepp has a PhD in Statistics, Masters in Industrial Engineering and a BA in Mathematical Economics and is someone I consider a must-read whenever he puts out research. Recently Sepp wrote a long piece on the recent events that have taken place in volatility and I’d like to share a few pulled quotes and charts below…

With Regards to the actual intraday event in XIV:

The most interesting and yet mysterious incident happened right after cash market close at 16:00 while the futures market was still opened. From 16:00 to 16:15 the intraday gain in the VIX1m futures reached from 45% to nearly 100% indicating the default event for XIV ETN and other short volatility ETP. At the same time the loss on the S&P 500 index futures increased only by about 1.25% to 5.5%. As a result, the more than double spike in the VIX1m futures during this 15-minute period cannot be accounted by the decline in the S&P 500 index futures.

Below is my brief summary of the points Sepp gives  for the day’s events. #4 is what’s gotten the most attention and likely had the largest impact:

  1. There’s no easy way to arbitrage the intraday moves in XIV and unlike ETFs, there are not redemption mechanisms in place for ETNs like XIV.
  2. If Credit Suisse was hedging its exposure via swaps then their counter-party could have been hedging its own exposure through long VIX futures.
  3. Retail investors shedding XIV exposure added to pressures at close.
  4. Re-balancing of short and long volatility products exacerbated the rise in volatility . short volatility ETPs had to buy VIX futures to cover their short positions to get in line w/ their reduced NAV and long volatility ETPs had to also buy VIX futures as their NAV increased.

One topic that hasn’t received as much attention is why spot VIX rose as much as it did with the equity index declining by less than five percent. Sepp notes that following a regression model of the sensitivity of S&P to VIX estimates that a -10% decline in the index would result in a 31% increase in VIX front month futures. However, as Sepp’s chart below shows, What happened on February 5th was well outside the norm. Based on the regression model, the S&P would need to decline by 26% to get a 100% increase in front-month VIX.

So something must have changed or impacted the sensitivity of the VIX to the S&P 500.  Sepp looks at the absolute level of the VIX to determine if the fact that the Volatility Index was at an extremely low-level had any impact on the resulting move. By grouping the VIX into four regimes (less than 14, 14-17, 17-22, and greater than 22) does not have a substantial impact on VIX’s beta.

However, what does seem to have a large sensitivity to the level of volatility, is convexity, which measures the responsiveness of the acceleration in change of prices. As Sepp’s chart below shows, when the VIX is low, the convexity is heightened, meaning the change in the S&P has a much larger impact on the change in the front-month VIX futures. Using the prior -10% drop in SPX would result in a 109% rise in VIX futures under 14 based on convexity  alone (e.g. not accounting for beta).

What makes February 5th’s move so interesting is typically the S&P 500 sees its largest downside moves when the VIX is at higher levels. For example, the Flash Crash in May 2010 occurred well off the lows in volatility. Spot VIX opened on May 6th, 2010 at 26, having been under 16 just a few weeks prior. Although, VIX also had been rising going into February 5th, with spot bottoming under 10 in January but VIX still opened on the 5th at sub-20 which as Sepp’s work shows, allowed a much larger impact of convexity to take hold – and the resulting volatility dominoes to fall as they did for volatility ETPs.

Short version: The events that took place on February 5th, while not outside the scope of reason, did occur at near-perfect storm levels with volatility in a regime of heightened sensitivity to convexity. As I discussed in my paper, Forecasting A Volatility Tsunami, low volatility is not a good predictor of spikes in volatility but as Sepp’s work shows, low volatility can provide additional fuel to the volatility fire when spikes do in fact occur. Could this happen again? Mathematically, yes.

While the criminalization of volatility products is overblown in my opinion, likened to the idea that race cars should be banned if an amateur attempts to get behind the wheel and crashes, like all investment products, but specifically those linked to futures, the end-user needs to understand and evaluate what they are buying and the risks involved.

To read the entire piece by Artur Sepp: Lessons from the crash of short volatility ETPs

Disclaimer: Do not construe anything written in this post or this blog in its entirety as a recommendation, research, or an offer to buy or sell any securities. Everything in this post is meant for educational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in the blog. Please see my Disclosure page for full disclaimer. Connect with Andrew on Google+, Twitter, and StockTwits.

Where Equities Could Potentially Be Headed From Here

Whenever we get large moves in the market I like to keep my analysis of where things could potentially be going as simple as possible. It’s easy to throw a bunch of indicators on a chart, a few cycles, trend lines, and maybe a sketch of a dragon and call it a day but what’s truly helpful is often what’s the most basic. So I thought it would be good to take a look at some simple daily and weekly charts of the S&P 500 and see where potential support (if we get declining) and resistance (if we bounce) could come in the near future. Let me start by saying I’m writing this on Sunday, so some of these levels may even get taken out once pre-market trading begins, based on how price moved last week…anything is possible.

First up we have the a daily chart of the S&P 500 ($SPX) with two simple moving averages and the Relative Strength Index (RSI). Not long ago there major financial news networks dedicated quite a bit of airtime and column inches to the high level of momentum the market was experiencing. How quick things can change. We’re now seeing the RSI momentum indicator under 30, deemed as ‘oversold’ by mean practitioners. What does this mean? Just that there’s been a strong move towards the downside as sellers have out-muscled buyers. Over the last few years when the RSI has gotten under 30 we’ve seen a bounce in equity prices, will that happen this time as well?

Turning the focus to the price chart, on Friday the S&P kissed its 200-day Moving Average (blue line), which isn’t a huge surprise as it seemed at the time that just about everyone was laser-focused on the 20-day MA and while not an algo trader myself, I have little doubt that there are some major algorithms trading this market that probably have the 200-day MA as a trading rule. In fact, while at the Inside ETF Conference just a few weeks ago I met a wholesaler who had an ETF that’s entire strategy was on whether the S&P was above or below the 200-day Moving Average. I’ve also included 1-year (red line) moving average as I think the market often ‘respects’ its 1-year average price. We can see examples of that in June ’15, June ’16, and Nov’ 16. We obviously broke below both of these long-term moving averages during the correction/bear market of late-2015.

Now lets focus on the weekly chart of the $SPX. Again, keeping these super simple. We have just a 50-week moving average and a 20-week MA. I’ve noticed that often times when the 20-week MA has been broken, the 50-week has a fair job at ‘catching’ price as support. We saw that play out in 2010, 2014, and twice in 2016. Meantime, the 50-week failed during the larger downside move in 2011 and of course in 2015.

On the bottom panel I’ve put an indicator that shows how far we’ve come from the 10-week Moving Average (would also be the 50-day Moving Average) along with two lines. The top line simply shows where we are now, 3.528% below the 10-week MA and the second line shows if we were to continue to decline and become 5% below the moving average. I think it’s interesting to see that we’ve declined several times approximately 5% below the 10-week during short-term corrections in the past.For example in 2010, 2012, and twice during the decline in 2015. It seems since 2009 that traders have found value in stepping back in to the market after a decline of that magnitude. So basically just another nearly 1.5% to the downside would still keep us within a normal market environment as we’ve experienced over the last 7+ years.

Okay, so what if we do see a bounce and price starts heading higher, what could be some potential resistance levels we should be aware of? The two main ones I’ll be keeping an eye on are the 50-day Moving Average and the 50% retracement. Let me start with the retracement…. I’m the first tell you I’m not a fan of Fibonacci, I wrote about it back in 2013 and you’ll rarely see me ever use it on a chart. There are plenty of other traders that I have great respect for that do use it, have success with it, and that’s great. Personally, I prefer market tools that are directly derived from price and not something that was invented to measure the reproduction of rabbits. Technically, I’m still not using Fib by referencing a 50% retracement as a .50 is not actually a Fibonacci number. It is however, a component of Dow Theory as it’s believed the market often will produce a counter-trend retracement of 50% of the prior move. Using closing values, that would put us at 2,725 which is also right about the same level as the 50-day MA. The fact that these two levels are so close, leads me to think there could be a build up of supply in the market at that point if price does rise another 106 points.

As I wrap up this short post let me emphasis that in each explanation above I use the word ‘potential’ quite a bit – and that’s on purpose. As a trader I keep an open mind to what the market could do without naively thinking I know what the market will do. The above three charts aren’t the only tools in my toolbox I use to evaluate the market, I also spend a great deal of time looking at inter-market relationships (i.e. sector relative strength, asset class performance, etc.) as well as market internals (breadth and sentiment, volatility). As we move into a new week I’ll be very interested to see how price moves and if traders become eager to step back in and retrace a piece or all of this technical-driven decline or of more weakness is on the horizon as loose hands continue to get shaken out.

Disclaimer: Do not construe anything written in this post or this blog in its entirety as a recommendation, research, or an offer to buy or sell any securities. Everything in this post is meant for educational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in the blog. Please see my Disclosure page for full disclaimer. Connect with Andrew on Google+, Twitter, and StockTwits.

Discussing Volatility at a University of Chicago and CMT Chapter Joint Event

What a time to be having a discussion around volatility with the VIX spiking by one of the largest amounts in its history and equity markets seeing triple and quadruple digit single-day declines!

On February 15, I’ll be giving a presentation on my Charles H. Dow award winning paper, Forecasting a Volatility Tsunami in a joint event with the University of Chicago and the Chicago CMT Assoc. Chapter. I’ll be going over the importance of managing down side risk within a portfolio and diving into the topic of my paper concerning the Volatility Index. This event is open to CMT members and non-members, so if you’re in the Chicago area you’re welcome to attend.

For more details and to register: Chicago Chapter Meeting featuring Andrew Thrasher, CMT

Week In Review: Index & Sector Returns, Volatility, Gold, Options Activity, & The Super Bowl

So Friday was fun. The Dow dropped 665 points with the major U.S. equity indices dropping 2%, erasing a chunk of the abnormally large gains captured in January. A great deal of attention was given to the lofty level reached in the 14-day Relative Strength Index, as it got to near 90. Well that’s now been corrected, with momentum indicator falling under 70. It’s often said that the market rarely bottoms on a Friday as traders become nervous holding long exposure into the weekend. With that, I’d be surprised if we didn’t see a little bit more selling pressure, especially after sentiment readings got as high as they did in January. However, the earnings data appears to be coming in strong for Q4, so the dip buyers will likely still have a bit of confidence left before completely abandoning ship. It’s important to remember that this type of price action, you know, prices actually moving in more than one direction, is normal. It’s amazing the number of calls I’ve seen published this weekend calling an end to the bull market simply because the S&P is off at high by a couple of basis points – truly amazing.  Alright, let’s get into some of the charts that highlight the developments from last week’s sell-off.

Index Returns 
The Dow started the year as the strongest index between the Nasdaq, NYSE, R2K, and the S&P. After last week’s decline the Russell 2000 has moved into the red year-to-date.

Sector Return
Year-to-Date sector returns show four of the major S&P sectors now under-performing the major index and down on the year. Utilities have taken a hit with the rise in interest rates, followed by Energy, Materials, and Consumer Staples. Meanwhile, Consumer Discretionary (cyclical), Financials, and Health Care are currently the best performing sectors for the start of the year.

Equal Weight vs. Cap Weight S&P 500
As I mentioned with the first chart as small caps are now negative YTD, the down trend of equal weight vs. cap weight S&P 500 has now declined to 2012 levels. Having been a theme for most of 2017, the largest components of SPX have led the drive higher, erasing the relative strength RSP put in during 2016.

Equity Put/Call Ratios
With Friday’s large move lower, an interested development took place in the three put/call ratios. We saw a large pick up in put buying relative to call buying in equities while investors actually seemed to be buying the dip in index options, shifting the index put/call ratio to one of the lowest levels seen int he last few years.

I last showed this chart in a post in August, questioning the advance in gold that wasn’t being confirmed by the yen. The shiny metal went up for a few more days before sinking back to $1,240/oz. We then had a bullish divergence in the yen, as it put in higher lows as gold was making a lower low – once again gold flipped direction and headed higher as it confirmed what the yen was telling us. Now we have a replay of what we saw in August as the yen has yet to get back the upper-end of its 12-month range while gold has created a false breakout from its August high. The break of $1,350 without the yen was tough for gold to sustain, so the move lower isn’t too much of a surprise. The yen has now begun to roll over, putting additional pressure on gold prices.

One of the big stories from Friday was the large move in the $VIX, which spiked 28% on Friday and over 50% for the week, shown by this CBOE table. The largest move in volatility was in the 9-day VIX ($VXST) with volatility across most of the measured instruments rising double-digits last week. However, volatility for IBM, Apple, Amazon, and Google were actually flat or lower on the week after the large tech companies reported earnings, taking some of the air out of the volatility ramp-up into their reports.

Volatility Rises 50%
Yes, discussing the VIX in percentage terms isn’t technically correct since it’s a percentage itself, but stick with me for a second. Steve Deppe shared this interesting chart, looking at previous times the Volatility Index has risen 50+% in a single week. Like last week, many of the previous instances also had the VIX finish above its upper Bollinger Band. While the sample size is admittedly small, the following moves in volatility have historically been largely lower, averaging a 1-week decline of 11% in 80% of the periods. In fact, two weeks later the VIX was only higher 10% of the time. Josh Brown also shared on his All Access Twitter account a stat from Ari Word, CMT that the S&P 500, when it’s still above its long-term moving average, 13-weeks after the VIX has moved 50% higher is up on average 4.5% vs. just 2.1% in all periods since 1990. So while the historical expectation in the intermediate term is for volatility to come back down, previously this time of spike in the VIX has acted as a nice propulsion high for stocks as well.

Spot VIX Rises Above All VIX Futures
Tom McClellan shared this interesting point over the week, highlighting that spot VIX moved above all VIX futures contracts during trading on Friday, something its typically only done int he resent past during periods of economic or geo-political events. The prior two occurrences being Brexit and the U.S. election. While this condition can persistence or repeat itself before equities ultimately find a low, like we saw several times in 2015, it is a development that’s often led a move higher in stocks.

Volatility Podcast Interview
I recently spoke with Andrew Swanscott on his podcast, Better Systems Trader about my Charles Dow Award paper on volatility spikes, if you’d like to give it a listen here’s the link: Forecasting a Volatility Tsunami with Andrew Thrasher.

Super Bowl Winner
Naturally there will be lots of commentary and tweets on Monday morning about who won the Super Bowl and the market’s resulting rise or decline. The two aren’t correlated, don’t waste your time reading about it….



Disclaimer: Do not construe anything written in this post or this blog in its entirety as a recommendation, research, or an offer to buy or sell any securities. Everything in this post is meant for educational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in the blog. Please see my Disclosure page for full disclaimer. Connect with Andrew on Google+, Twitter, and StockTwits.