Volmageddon and the Failure of Short Volatility Products

Abstract

The rapid growth of exchange-traded products (ETPs) has raised concerns about their implications for financial stability. A case in point is the abrupt market crash of short volatility strategies on 5 February 2018. In this article, we describe this “Volmageddon” event and illustrate the risks associated with hedge and leverage rebalancing when markets are highly concentrated and volatile. The Volmageddon episode provides valuable risk management lessons because it illustrates the pitfalls of hedge and leverage rebalancing and is reminiscent of the losses incurred through portfolio insurance schemes.

Editor’s Note

This article was externally reviewed using our double-blind peer-review process. When the article was accepted for publication, the authors thanked the reviewers in their acknowledgments. Pedro Barroso and Joanne M. Hill were the reviewers for this article.

Submitted 6 August 2020

Accepted 1 April 2021 by William N. Goetzmann

Declaration of Interests

Disclosure: The authors are not aware of any conflict of interest that may affect the impartiality of their analysis.

Editor’s Note

This article was externally reviewed using our double-blind peer-review process. When the article was accepted for publication, the authors thanked the reviewers in their acknowledgments. Pedro Barroso and Joanne M. Hill were the reviewers for this article.

Submitted 6 August 2020

Accepted 1 April 2021 by William N. Goetzmann

Acknowledgments

We are grateful to the executive editors, Stephen J. Brown and William N. Goetzmann; the co-editor, Luis Garcia-Feijóo, CFA; and the managing editor, Heidi Raubenheimer, CFA, for invaluable feedback. We also thank Sebastien Betermier for useful comments and suggestions. Ludovic Van den Bergen acknowledges the support of the Marcel Desautels Institute for Integrated Management at McGill University.

Notes

¹ The term “Volmageddon” (a combination of “volatility” and “Armageddon”) quickly emerged in trader forums following the 5 February 2018 volatility crisis and has been extensively used in the popular press (e.g., Hunnicutt 2018; Popik 2018; Wigglesworth 2018; Kawa 2019).

² Bhansali and Harris (2018) also highlighted this crowded-trade risk.

³ We provide further evidence, based on Cheng (2019), on these issues in Appendix A. Table A2, which reports pairwise correlations between daily XIV and SVXY returns, percentage changes in the VIX, percentage changes in the S&P 500, the futures basis (futures price minus spot VIX), and the estimated price premium (futures price minus expected spot VIX) for 2012–2017, supports the idea that inverse VIX ETPs provide exposure to market price and volatility movements. Table A3 reports estimates of capital asset pricing model (CAPM) performance regressions for the XIV and SVXY. Table A3 supports the idea that inverse VIX ETPs offer investors leveraged market exposures with CAPM betas around 4.0. Table A3 also shows that timing estimated price premiums can earn positive alpha from VIX ETPs, which is consistent with the literature.

⁴ The after-hours market typically has much lower liquidity than the regular market, motivating trade during regular hours. The Cboe recently changed the daily settlement time of VIX futures to 4:00 p.m. to align more closely with the closing time of the stock market. Fund managers also use trade-at-settlement (TAS) orders to rebalance. Huskaj and Nordén (2015) provided a detailed discussion of the TAS market.

⁵ See Detzel et al. (2019) for similar estimates and Barroso and Detzel (forthcoming) for estimates of transaction costs in the context of volatility-managed portfolios.

⁶ On 31 January 2018, the AUM of 2× volatility futures funds were $283 million for the TVIX and $427 million for the UVXY (according to Bloomberg data), which amounted to a total AUM of $710 million. The actual increase in the funds’ AUM is not available but should be approximately equal to the promised performance: 2 × 39% = 78%.

⁷ The actual increase in the funds’ exposure is not available but should be approximately equal to the market return on that day—that is, +39%.