24/7 Wall St.

Explaining volatility in the stock market is no simple process. To much of the investing public, stock market volatility just sounds like price gyrations. To professional investment managers, volatility is measured in multiple ways. Not all of those ways are going to sound all that good for the broader markets in general. And to add insult to injury, the economic fundamentals this week are just not all that different from the fundamentals of the prior week, after considering Friday’s wage inflation and Federal Reserve rate hike fears.

There are some similarities to the volatility trade and the “short volatility” trades actually creating moves in the underlying equity markets being similar to credit default swaps (CDS) ahead of and during the financial crisis of 2008 to 2009. It turns out that the tail can end up wagging the dog, if you consider that smaller trades and bets can create larger moves in the underlying securities.

24/7 Wall St. wanted to outline just how complicated the world of volatility and the “short volatility” can be. If it was simple, everyone would understand it. We have shown some of the exchange traded fund (ETF) and exchange traded note (ETN) products and have featured some of the key exchanges around the market rout. We also have outlined some strategic calls from analysts and advisories for those investors who are interested in looking through the mess to the other side.

Intercontinental Exchange Inc. (NYSE: ICE), which owns the New York Stock Exchange (NYSE) and many other exchanges, was last seen down just 1.3% at $70.50 right before noon Eastern Time on Tuesday. It was just on Monday that the ICE announced a record trading week for the NYSE FANG+TM Index futures contract. According to the NYSE Trader alerts page, the Proshares Short VIX Short-Term Futures ETF (SVXY) even had trading price adjustments and its shares were halted. The NYSE said:

NYSE Arca is adjusting the re-opening auction reference price for SVXY (ProShares Short VIX Short-Term Futures ETF) from the prior day’s official closing price to the Intraday Indicative Value (as of 11:00am) of $11.4111. As a result, the lower and upper re-opening auction collars will be $10.84 and $11.98 respectively.

Shares of the CBOE Global Markets Inc. (NASDAQ: CBOE), which of course operates markets for many of the options that trade hands, was last seen down 11.4% at $115.65 on more than four times normal volume of 4.3 million shares as of noon Eastern Time. The CBOE has a video explaining some of Monday’s VIX trading activity.

https://www.youtube.com/watch?v=U3mudcOP_Y4&feature=youtu.be

Virtu Financial Inc. (NASDAQ: VIRT) had its CEO speak on CNBC after the close of trading on Monday noting that an avalanche of sell orders that came in around 3:00 p.m. were the cause of the massive sell-off rather than the computers. Their take was that the market computers functioned normally from the high-speed trading firm. They saw no busted trades and no repricing. That CNBC video can be seen here.

Credit Suisse announced the event acceleration of its XIV ETNs on Tuesday morning. The SEC filing signals the end of the ETN:

Because the intraday indicative value of XIV on February 5, 2018 was equal to or less than twenty percent of the prior day’s closing indicative value, an acceleration event has occurred. Credit Suisse expects to deliver an irrevocable call notice with respect to the event acceleration of XIV to The Depository Trust Company no later than February 15, 2018. The date of the delivery of the irrevocable call notice, which is expected to be February 15, 2018, will constitute the accelerated valuation date, subject to postponement due to certain events. The acceleration date for XIV is expected to be February 21, 2018, which is three business days after the accelerated valuation date. On the acceleration date, investors will receive a cash payment per ETN in an amount equal to the closing indicative value of XIV on the accelerated valuation date. The last day of trading for XIV is expected to be February 20, 2018. As of the date hereof, Credit Suisse will no longer issue new units of XIV ETNs.

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A note that went out from the derivatives team at Jefferies outlined how all the “short volatility” trading can blow out the markets. One issue pointed toward $3.8 billion in ETF/ETN products as of last Friday, creating $40 billion of S&P 500 futures that would have to be sold under inverse volatility ETNs. And their view is that it’s almost impossible to quantify the tail risks with such a huge array of strategies with components that attempt to short volatility. That being said, they have seen estimates ranging from “a few hundred Billion to a trillion+.” And here is the reminder about how the market can fluctuate now: “No one has ever traded a market with these Short Volatility products and dynamics before.”

Barron’s also wrote a piece called “‘Short-Vol’ Was a Money Maker … Until It Wasn’t.” showing how the “can’t-miss” trade of 2017 is blowing up even as it helped send stocks plunging Monday.

The NYSE shows how its circuit breakers will be kicked in during times of market volatility due to one-off events like Brexit and fluctuations in interest rates causing unanticipated volatility. A marketwide trading halt can be triggered if the S&P 500 Index declines as 7% (Level 1), 13% (Level 2) and 20% (Level 3). These are the rules for such halts:

• Level 1 or Level 2 circuit breakers after 9:30 a.m. ET and before 3:25 p.m. ET will halt market-wide trading for 15 minutes, while a similar market decline at or after 3:25 p.m. ET will not halt market-wide trading.
• A market decline that triggers a Level 3 circuit breaker (-20%) at any time during the trading day will halt market-wide trading for the rest of the trading day.

A Swiss private banking group called J. Safra Sarasin issued a global equity strategy note on Tuesday showing how disruption in volatility rolled the stock markets. Its report points out that economic fundamentals haven’t changed but how more expected jitters could be seen. The note further pointed out:

There is mounting evidence that providers of short volatility exchange-traded products (ETPs) ran into serious trouble when they needed to trade adequate amounts of VIX futures to rebalance their positions. The volatility “tail” seems to have wagged the equity market “dog”, creating a negative feedback-loop in volatility futures and finally equities.

Janney issued a technical strategy report as a market correction toolkit. The report points to 30-week and 30-month moving averages, pointing to Dow support first, as in the 23,470 zone on a weekly closing basis and down 11% from all-time highs late in January. On the monthly charts and using the 30-month averages lead to secondary support for the Dow being closer to a range of 19,000 to 20,000. Its report said:

We would expect a counter-trend move/rally to commence soon – however, our belief is that we have not yet seen ultimate exhaustion of selling pressures. Furthermore, despite the reduction of short-term overbought pressures, the markets remain extended on a longer-term basis and thus vulnerable to further volatility ahead.

Credit Suisse issued a stock market volatility bulletin dated February 5, but this was ahead of some of the key panic selling. Its message: “No Panic (Yet) in Equity Vol Despite Sharply Higher Rates.” The report noted how the VIX Index surged to a one-year high last week but how there has been very little panic in the options market. That synopsis said:

The increase in implied was primarily driven by the SPX realized move. While the equity-rate correlation has now turned negative, such a breakdown in correlation is rarely sustained. History suggests that rapid increases in bond yields are often short-lived catalysts for higher VIX.

Anyhow, this is a bit of a “vol and short-vol” buffet, but it will hopefully explain a bit more about how the market disconnect looked considering that the economic fundamentals have not changed since last week.