Stuart Barton, PhD, CFA I November 24, 2020
Invest In Vol is becoming a leading user of VIX Exchange Traded Products (ETPs) to deliver its clients volatility linked alternative investments - specifically strategies that seek to benefit from both rises and falls in implied volatility. As Invest In Vol’s use of VIX ETPs grows, clients have rightly enquired into the impact that our strategies, and the ETPs that underlie them, may have on the broader equity market. In this article, I attempt to answer that question by explaining the mechanism through which the VIX ETP market and the S&P 500 are linked, and to quantify the scale of any interaction between them.
During periods of market volatility it is frequently argued that popular VIX ETPs - like the iPath S&P 500 VIX Short Term Futures ETN (VXX), ProShares Short VIX Short-Term Futures ETF (SVXY), and the ProShares Ultra VIX Short-Term Futures ETF (UVXY) - have a destabilizing impact on the broader US equity market. More specifically, it is argued that growing assets under management (AUM), and a significant net long or net short exposure in VIX ETPs could have an impact on the S&P 500 market through the delta hedging activity of dealers and market makers rebalancing their hedges for their VIX ETP positions. Given the considerable volatility encountered in 2020, and the vast changes in the volatility ETP market, I thought now might be a good time to revisit this argument.
VIX ETPs are an important part of the US equity volatility market, offering market participants a simple way to hedge or take exposure in the implied volatility markets without the need for the complexity of managing a portfolio of options or futures. The rise of VIX ETPs has opened up the volatility market to a broader group of sophisticated participants and has rebalanced the market in favor of more cost-conscious investors.
Despite these positives, VIX ETPs have come under criticism for shortcomings in their design, and in some cases, have been misunderstood. For example, some poorly informed commentators have implied that an investment in the VXX is an investment in the VIX - it is not - and the growth of VIX ETPs has even been blamed for increasing volatility in the equity market. This demonstrates a need to further develop public understanding of how VIX ETPs fit into and interact with the broader financial market.
An alarming criticism of VIX ETPs has been that dealers could be increasing the volatility of the S&P 500 by Gamma hedging their positions. Gamma hedging is the buying and selling of an underlying - equity index futures in the S&P 500 in this case - to delta hedge their volatility linked positions, and the assertion is that this buying and selling could impact the S&P 500 if this activity grew large enough. Gamma is a measure of the amount of additional Delta (stocks and/or S&P 500 futures) that need to be bought (or sold) when the Index moves by 1%. For example: $1m of Gamma indicates that if the S&P 500 Index was to move 1% in either direction, a trader would need to buy (or sell) $1m worth of stocks and futures. If a trader is long options, they will be long Gamma meaning each time the market rallies they will be selling delta, and each time it falls they will be buying delta – a comfortable position to be in, selling high and buying low. However, the opposite applies when the trader is short options and therefore short Gamma. Each time the market rallies the trader is forced to re-hedge by buying stocks and futures, and each time it falls they have to sell those stocks and futures. This can be costly!
However, the GROSS sum of the AUM in all VIX ETPs may not be as important as the NET position long or short in these ETPs and who holds them. For example, two investors with opposing views on the future of implied volatility might buy and sell a unit of VXX between themselves effectively creating a contract for difference, and this transaction is likely to have no impact on the greater volatility market, or the volatility of the S&P 500. If VXX rises, the investor who is long will profit while the investor who is short loses. The net impact to the underlying S&P 500 options - and volatility market as a whole - of this type of position is likely to be zero, which is to say that no net exposure is passed on into the S&P via the options market.
However, VIX ETPs do not always offset in this way, and there are times when traders looking to take outright directional views on volatility are heavily biased to the long or short side. When this is the case, and when end users of volatility products - i.e. those seeking to take a position rather than hedging it with other volatility products - are net long products like VXX, it is likely that professional market makers and dealers are on the other side and net short these products. Unlike end users, market makers and dealers make their money from flow and not from outright position taking and typically hedge their volatility exposure with whatever products suit them best - most frequently in this case VIX futures, S&P options, and/or Variance Swaps. As a quick note: because VIX futures and S&P 500 variance swaps (see my previous article on this subject) are effectively just contracts for difference and merely move the risk from one trader’s book to another, ultimately all of these hedges find their way back to the S&P options market.
Now this is where things get interesting. If end users are net long (or net short) volatility via VIX ETPs, dealers will be left net short (or net long) implied volatility through VIX ETPs, and as a result be inclined to take a net long (or net short) S&P options positions as a hedge. This sets up an interesting dynamic that could in theory, and if large enough, have an impact on the broader equity markets.
So how might this affect volatility in the S&P 500? The answer lies in the differing dynamics of VIX ETPs and S&P 500 Index options. Delta hedged options used to hedge VIX ETPs by dealers need to be re-hedged each time the S&P Index moves up or down – this is known in the derivatives world as Gamma hedging, and refers to the amount of additional Delta (stocks and S&P futures) that needs to be bought (or sold) when the Index moves. Being long Gamma would mean the trader will be selling delta each time the market rallies, and buying delta each time the market falls – effectively selling high and buying low - a situation that could reduce S&P 500 volatility by selling into market rallies and buying dips. The opposite of course applies if the trader is short options and short Gamma.
Could the gamma position created by a net long or short position in VIX ETPs ever grow large enough to have a meaningful impact on the broader equity market? Well in theory yes, but it would require an extremely large one-way position is the VIX ETPs.
So, let’s work out how large a net VIX ETP position would have to be to have a meaningful impact on the equity market. The most liquid hedge for the broad US equity market is the CME’s S&P 500 E-Mini futures that has recently been trading with good volume of around 1.5 million contracts per day on reasonably calm days (let’s say a day when the market moves less than 1.5%), and significantly more on volatile days. The multiplier on these contracts is 50, and the most liquid December contract is trading at a value just over 3,500. This amounts to about $250bn dollars of S&P 500 delta traded each day in the E-Mini’s.
Now let’s assume that to have a meaningful impact on the S&P 500 market, net ETP gamma would have to contribute 25% of the daily delta traded in the underlying market. In delta terms that would be approximately $60bn of S&P 500 delta as a comfortable cap on reasonably calm days. The same 25% portion of the volume on more volatile days (typically twice or more of the volume of quiet days) would of course account for considerably more futures, but as a conservative estimate of the market impact of the ETPs I’ll use the smaller $60bn number for a day with a typical smaller than 1.5% move in the S&P 500.
Now, remember that Gamma is equal to the change in delta for a 1% move in the underlying. So, an $60bn delta change for a 1.5% move would equate to $40bn per 1% move, or a Gamma position of $40bn.
Now let’s also assume that a reasonable proxy hedge for a 1 month rolling VIX futures ETP (like VXX, SVXY, and UVXY) might be a strip of 60-day S&P 500 options, or to really simplify things, a 60 day at the money straddle. I’ll use 60-day options as a proxy because the average maturity of the VIX futures held in a VIX ETP’s portfolio is about 30 days, and the VIX itself references 30-day volatility beyond that.
Still following? Well this is where things really get interesting. A $40bn gamma exposure in 60-day options presently amounts to approximately $2.5bn of Vega – the dollar amount of exposure to changes in implied volatility. This would be a very large Vega position, but how large in VIX ETP terms?
Well, we can calculate this by multiplying this resulting Vega by the price of the futures held by the VIX ETPs to get the corresponding ETP AUM. This is because a single VIX future priced at 25 exposes the holder to 1 volatility point for every 1/25 of its price move. So, $2.5bn of Vega, at an average VIX futures price of 25, would indicate an AUM of about $100bn before the VIX ETPs began to meaningfully impact the S&P 500. An absolutely massive number compared to the present and historic holdings of VIX ETPs! Readers should be able to calculate this themselves using an online option pricer or a Bloomberg terminal, and, for the sake of this example, I have used a 24% vol and 50 delta puts and calls.
Presently the VIX ETP market is dominated by three products – VXX, SVXY, and UVXY - accounting on November 19, 2020 for $935m, $386m, and $1,289m respectively. Given that each ETPs leverage factor 1x for VXX, -0.5x for SVXY, and 1.5x for UVXY, these products presently equate to a net AUM of (1x of $935) + (-0.5x of $386) + (1.5x of $1,289) = $2.65bn, a mere 2.7% of the 100bn I have estimated above would begin to have a meaningful impact on the S&P 500.
I think it’s reasonable to say that the VIX ETP space is still a minor part of the US equity market as a whole, and their size would have to grow substantially before they had any meaningful impact on the S&P 500. Added to this, it is likely that if the VIX ETPs grew, liquidity in the underlying VIX futures, S&P options, and S&P 500 futures would also likely grow to facilitate some of that growth. An interesting finding, I think.
Footnotes  https://www.cmegroup.com/trading/equity-index/us-index/e-mini-sandp500_quotes_volume_voi.html#tradeDate=20200916  https://www.ipathetn.com/US/16/en/details.app?instrumentId=341408  https://www.proshares.com/funds/svxy_daily_holdings.html  https://www.proshares.com/funds/uvxy_daily_holdings.html
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