
How Two Tiny Volatility Products Helped Fuel a Sudden Stock Slump - paulpauper
https://www.bloomberg.com/news/articles/2018-02-07/how-two-tiny-volatility-products-helped-fuel-sudden-stock-slump
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joe_the_user
Sure, this is an article from this year but it certainly needs something like
a [FEBRUARY] tag on the title given they aren't talking about the recent
slump.

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lordnacho
Former vol trader here.

This is an old article but the dynamic is always applicable. Your main issue
is that anything that isn't statically replicating, ie simply holding a
constant basket of whatever it's supposed to track, needs to rebalance. The
bigger the deviation the more unfavourable that is. What vol traders call
negative gamma or convexity if you are from the fixed income world. The
problem is you are pushing the wrong way on prices when you need to rebalance.

The thing is the markets have been in a very low vol environment for a long
time, possibly ending in the last couple of months. We'll see. But until then
it was quite a popular trade to be short options.

You can Google optionsellers.com to see what happens when things go wrong.

~~~
imh
It sounds like this applies to broad total market index funds too. I still
feel like I don't know shit about the stock market so forgive me if that's a
101 question.

If I am an index broadly tracking the market, weighting each stock by market
cap or whatever, then if it goes up, I have to buy more. If it goes down, I
have to sell. Is that right? Is the that kind of rebalancing you're talking
about?

It sounds like a positive feedback loop that could run away. Stock X goes
down, forcing some index to sell it, forcing it further down, forcing them to
sell more, etc.

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teej
If you’re keeping a balanced portfolio of assets and the price of one goes up,
you _sell_ to rebalance, not buy.

~~~
guelo
Is that because the underlying indeces are defined as each asset being a fixed
percentage of the whole? Like, hypothetically, the S&P 500 would define MSFT
as 1% of the index so if MSFT goes up then the fund would have to sell it to
keep it from being more than 1% of the total holdings?

~~~
Godel_unicode
For what it's worth, the S&P 500 uses float-adjusted capitalization weighting.

[https://en.m.wikipedia.org/wiki/Capitalization-
weighted_inde...](https://en.m.wikipedia.org/wiki/Capitalization-
weighted_index)

~~~
guelo
After reading more about stock index funds I'm more confused how their
rebalancing works. I now understand that the S&P 500 index is basically the
total market cap of the free float of the 500 companies combined. I just don't
see why a tracking fund would have to rebalance at all. If you own the 500
stocks at the right proportion it should stay balanced as each company's
market cap grows or shrinks relative to all the other companies. The only time
you would have to rebalance is when companies are added or removed from the
index.

~~~
pmart123
It seems like you mostly have a good understanding of how it works. A tracking
fund would have to rebalance in the advent of a company issuing or buying back
shares, when there is a corporate action like a spinoff or merger, or when a
company is added or removed from the index.

Additionally, you have the reality that every day, investors buy and sell that
fund. The tracking fund, therefore, has to liquidate or buy new holdings to
match the NAV (net asset value) as shares are created or redeemed. This is
where tracking funds will vary in their performance as some ETF providers
might be a lot worse at matching up inflows and outflows.

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paulpauper
A lot of people were wondering why the XVI and SVXY products collapsed so
quickly even though spot volatility was not up that much and SVXY and XV were
only down 15% for the day yet were down 80% the following day.

The answer is kinda subtle and most sources don't explain it well. The reason
is, volatility futures trade until 4:15 but the market closes at 4:00. So this
means SVXY and XIV reset at 4:15 instead of 4:00. This means the 80%
termination clause is not based on the market close but actually based on the
4:15 price of volatility futures close. In the after hours in that fateful 15
minutes, the futures saw a massive surge and crossed the 80% liquidation
threshold. After 4:15, SVXY and XV began to dive because at that point they
were dead, but the decline was initially gradual because most people did not
realize what had happened. That 15 minutes is what made all of the difference.

~~~
cm2187
Well, the VIX futures trade well after 4:15. What I don't understand is that
the collapse didn't happen just in the last 15min after the session but
progressively up to a an hour or two after if I remember. The underlying S&P
VIX strategy seems to be using a fixing as of 4:15 indeed per the S&P
documentation [1].

In any case, setting the fixing in the middle of an illiquid market was a
moronic decision and if I had been burned by this, that would be my potential
avenue for litigation.

Also I wonder how much of this short squeeze was amplified by other market
participants who anticipated this event could happen. Some trading desks made
a killing that day.

[1] [https://us.spindices.com/indices/strategy/sp-500-vix-
short-t...](https://us.spindices.com/indices/strategy/sp-500-vix-short-term-
index-mcap)

~~~
scott00
The fair value of SVXY at 4:15 using the usual formulas was around $4, but it
was trading around $70 at that time. However a lot of that price movement was
due to essentially flash-crash type movement in the last minute of trading in
the VIX futures. This introduced two problems for potential arbitrageurs. For
XIV, the problem was that it was possible that CFE would bust trades at the
extreme price levels, leading to a revised closing price and corresponding
payout on the ETN. For SVXY, the problem was that it was possible that the
extreme conditions had caused the fund managers to deviate from their target
position, and thus hadn't actually lost as much money as they were supposed to
based on their stated objectives. CFE never busted trades, but SVXY did end up
deviating significantly from their target position, in the form of not taking
off as much risk as they should have at 4:15. They ended up working the
remaining order slowly through the overnight session and the following morning
until about 10 am the next day. They got better prices on the make up hedge
than the 4:15 price, which is why it opened the next day around $11 (which was
a fair price) instead of $4. They made an extra $7/share by deviating from
their objective. It could easily have been much bigger, and speculation about
how much they hedged and at what prices is, in my opinion, why the price
movement wasn't immediate.

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totoglazer
Note this is from 11 months ago, February 2018.

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nsrivast
As a former equity vol trader turned software engineer, my lessons:

* derivatives are a leaky abstraction. Understand how the underlying securities work _all the way down_

* read the docs!

~~~
module0000
As a former software engineer turned algorithmic commodities trader, my
lessons:

* The VIX(futures contract) is the most accurate pulse of the equity futures market I have seen.

* The _price_ of the VIX is no more important intra-day than the _depth_ of the VIX's inside bid/ask.

* When VIX _depth_ adjusts, so do equity future _prices_ , over the course of 5-10 seconds.

* Be fast, I mean _really_ fast. Or better, program your trading platform to be fast so you don't have to.

~~~
mrich
Some questions:

Does this mean the majority hedges with VIX futures and the rest is just
arbitrage?

Where are you getting depth VIX data (is it available at IB)?

Is there historic data available somewhere to study this?

~~~
module0000
For your first question: I don't know, but I speculate the majority is
hedging.

Second: I get my data from CQG, but you can also get the same feeds from IB.
The specific exchange you need for VIX is
"CBOE"([http://www.cboe.com/vix](http://www.cboe.com/vix)). ampfutures.com is
a broker that offers this, but there are many(possibly better) others that
offer it as well.

Third: Historical data for the depth isn't available from any broker I have
used. That said - I'm a retail guy, and there may be options for institutional
traders that I'm unaware of. As a retail guy you _can_ buy this data though,
just not from a broker. IQFeed offers it(6mo back for market data, and 6mo for
1-tick resolution data) - but it's expensive. The last quote they gave me was
$1350/month for CME and CBOE tick-by-tick resolution with 10 levels of depth.

~~~
brobinson
Which broker are you using for execution? IB? Curious if there's a better one
for futures/futures options since I've started getting into them recently on
IB.

If it's not revealing too much, what kind of stop loss distances are you
generally using in your strategies (ticks)?

Are you using any kind of "walk forward optimization" in your testing?

You mention in another comment that you intentionally do not trade during
_expected_ market volatility. Do you have parameters for sitting on the
sidelines during _unexpected_ volatility, e.g., VIX over certain threshold,
time since last Trump tweet according to Twitter's firehose API (serious),
etc.?

~~~
module0000
For execution I use Tradovate(which uses Dorman Clearing LLC). They have low
commissions, and offer a membership to reduce commissions to $0(you still have
to pay exchange costs though). Before Tradovate, I had used AMP for execution,
but eventually left them over the cost of commissions.

I use a 8 tick stop and a variable profit target(a result of weekly re-
optimizing). Last week the target was 24, and the week before the target was
16. The stop loss value I don't like to change, and 8 ticks has been enough
for "good" entries. If I need more than 8 ticks, then I believe the entry
price is my mistake - not the stop loss value.

I perform optimization every Friday, using that week as the training data to
find the "best" thresholds for changes in depth before signaling a trade. Then
the next Monday, I'll use those new values all week(and repeat the cycle that
Friday). Basically - re-optimize every week. It's not a lot of work, just
input the starting date, click optimize, and wait ~20m for the outputs. I like
to keep track of each week's settings, with the plan to one day review their
changes, and try to reason about why those changes happened(I haven't done
this yet though, it's one of those one-day-I-ought-to ideas).

I don't have any algorithm parameters for unexpected volatility, the closest I
have is a condition that turns the automatic entries off if the nearest 4 bids
and asks(examining a total of 8 prices) contain more than 4 ticks of spread(no
bids or asks), and both sides limit orders sum to less than 30. I didn't add
that until sometime around Valentine's day 2018(that was not a good couple-of-
days). When that happens, it disables entries and sends me an SMS.

~~~
brobinson
Thanks for the answers!

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gammateam
I think the entire VIX formula should be restudied as the options market it
has been based on is very different now

The SPX index options and SPY ETF options now have 20 options series trading
at once at any given point in time.

There is a front series expiring every single day.

This is very different from 1993 when VIX started or the aughts or even last
year.

The volatility curve is front loaded by greed, but when opex was only
quarterly or monthly, this pile up could more accurately accumulate into the
VIX fear guage that we know and have studied comprehensively

Now with “fear” diluted amongst so many options contracts, I really think this
should all be reevaluated. The VIX index and VIX futures and VIX futures
options and VIX ETFs based on selections of VIX futures all rely on the
trading activity of SPX options, and this formula doesnt have the same inputs
anymore

~~~
tryptophan
Although there are a lot more options nowdays(heh), I'm pretty sure that the
VIX only looks at implied volatility in options ~30 days to expiry. So the
new, short term options do not factor into its calculation.

~~~
quantgenius
The VIX index is the average implied volatility of a theoretical set of
options trading 30 days out by interpolating the implied vols of a bunch of
options. However, what is being discussed here is VIX FUTURES. The price of a
VIX futures contract is whatever clears the market based on demand and supply
not some calculation (the prices of the options used for the VIX calculation
are also whatever clears the market, not something off some ideal volatility
surface but that is besides the point). More options, less options or whatever
don't make any difference.

While VIX futures do cash settle to the special opening quotation of the VIX
on expiration day, and while the correlation between the VIX index level and
the futures is quite high, they don't necessarily move in lock step or even
necessarily in the same direction.

While models that tell you what the theoretical price of something is are
great at potentially identifying situations where there are mispricings among
assets to each other, any mental model where the price of an asset is based on
some theoretical calculation is dangerous when trading. The prices of traded
things are based purely on demand and supply.

~~~
TimMurnaghan
The original VIX used to to be that. But for some time now (approx 2009) it's
been a synthetic variance swap made up of a weighted sum of the "bunch of
options" (weighted by square of the strike). The huge advantage that this
makes over an actual implied vol is that it becomes replicable. And it's close
enough to being the "fear index" of the popular press.

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heisenbit
The article is from February but it is worth studying the headline which puts
the problem on "two tiny" whatever. Looking back the market was around a top
and was struggling to move higher. Not a tiny issue more a major top.

Lesson: Study headlines for wishful thinking and draw conclusions.

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cjbenedikt
Why a Feb 2018 article now?

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module0000
It's a postmortem of the mini-crash we saw in February. No one was expecting
it, and it happened _very_ fast. One day the Nasdaq futures are trading at
7100, the next day they are at 6100. Moves of 100 points(a whole day's worth
of movement) were happening in 15-20 seconds. Just for some context, 100
points(on the Nasdaq) is $2,000 gained or lost, using the minimum size you can
trade.

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loeg
[February], not the recent slump.

