Monday, July 27, 2009

Is VIX Being Artificially Depressed by Increased Use of SPXU?

The continued drop in the VIX below the 25.00 level caught a number of traders by surprise, including this writer.

If one were to study last Friday’s Forces Acting on the VIX, it would not take long to determine that with very few exceptions, the fear and uncertainty associated with the forces in the graphic have been rapidly diminishing over the course of the past few months.

One of the forces that I mentioned has received very little attention and has likely been underestimated by traders – if accounted for at all. This is the growth of hedging substitutes for the SPX. As the VIX is strongly influenced by the demand for SPX puts, it stands to reason that any substitutes for SPX puts could ‘artificially’ lower VIX levels by diverting demand to alternative hedging products. Historically, these substitutes have included futures, options and various forms of swaps. With the increased interest in ETFs and particularly leveraged ETFs, however, the menu of substitutes has increased dramatically.

During the height of the financial crisis, I documented how many investors were foregoing SPX and SPY puts in favor of options targeted specifically on the financial sector.

With the introduction of the bearish -3x Short ProShares (SPXU), a triple ETF aimed at replicating -300% of the daily move in the SPX, I believe traders have found – and embraced – an alternative to SPX options that is starting to impact the VIX.

The graphic below shows how the recent increased volume in the SPXU just happens to coincide with the decoupling of the VIX and the VXN. The same factors are undoubtedly impacting volatility term structure as well and may explain some of the recent low readings in the VIX:VXV ratio.

I am leaving the title of the graphic as a rhetorical question for the moment, as one month of data will necessarily leave us far short of any sort of statistical proof. Do not be surprised, however, if SPXU and its +3x sibling UPRO continue to generate larger interest and volume, both as a hedging tool and as a speculative play. As leveraged ETFs based on the SPX increase their market share, interest in SPX puts – and absolute levels in the VIX– may see a significant decline.

For some related posts, see:

[graphic: VIXandMore]

77 comments:

Rufus Willy said...

Getting gutted like a trout in VXX with VIX up 6%- What gives?

Anonymous said...

Bill, stimulating post...

1. I would have thought that after much indirection, the impact of SPXU would eventually show up in SPX puts due to the intermediate markets makers hedging. The intricacies of this chain of relationships gives me a headache.

2. Are you suggesting that SPXU may become the tail wagging the VIX dog? Any reason to expect a similar impact on VXX?

3. Would you expect the "normal" VIX relationships to reassert themselves once SPXU volume establishes some "average" level?

Bill Luby said...

Rufus,

Part of what you are seeing with the VXX and VIX is what I call 'calendar reversion' (the link takes you to all articles with this label). There is also term structure decay (essentially losses due to rolling) at work -- a subject I hope to post on soon.

Finally, there is always the statistical history that VXX only moves about half of what the VIX does in percentage terms on a typical day.

Anon,

Thanks for the kudos. You make some excellent points (I have a similar headache) and raise some interesting questions as well.

It is much easier for me to try to be provocative then to come up with the answers to all the questions that get raised, but I can speculate as best I can.

Regarding the magnitude of the potential SPXU impact, I guess that depends largely on the ultimate volumes achieved by SPXU. Volume won't tell the entire story. Will most of the volume be day traders? How much might options volume on SPXU increase? (e.g., why not buy SPXU puts instead of SPX puts?)

As for VXX, I think there will be an effect, but probably not at the same level as the VIX.

I think your last question is the most interesting one. Ultimately, the future impact on SPXU-related volatility levels should be a function of the expectation of future changes in SPXU volume (or at least the portion of that volume that is an SPX put substitute)...so a flat volume trend in SPXU should indicate a stabilizing of the SPXU effect on the VIX. This could still mean, however, that the VIX stabilizes at a slightly lower level.

Clearly, I'm going to have to give this one a lot of thought -- and watch to see how the data falls.

Thanks for the questions,

-Bill

stonebat said...

about the structure decay issue, etfs like UNG and USO had the extreme contango issue that killed their NAV. when it became widely known issue among many people, it lowered the funds a bit... and that was the last low point. some call it the bubble burst of uncertainty... or whatever. i take the extreme contango condition as bullish sign to monitor closely. but i agree with you that the leveraged etfs & options might be killing vix for a while... but those leveraged etfs will die out and im sure vix will gain the traction again. btw... just look at the volumes of faz. geez...

Anonymous said...

If SPXU is going to dominate, I wonder why not create a new VIX index based on SPXU?

Man

Anonymous said...

The VIX is being depressed by the institutional investors' collective moves to primarily sell SPX options instead of buying them since the rally started in March. If you sell options, their prices drop and according to the VIX formula this lowers the VIX's value. Specifically put selling has a big effect on VIX's value as the square of the strike of the option resides in the denominator of the formula. Since out-of-the-money puts have smaller strikes, the fluctuations in their prices get amplified by the big weight. That's why put selling has a big effect on lowering the VIX's value.

It's a BIG stretch to say SPXU has any effect on the VIX's value. Remember: SPXU can't be used for hedging as it has UNLIMITED losses (unlike options buying, which have pre-defined limited losses).

quantivity said...

Presumably SPXU MM's hedge with ES or SPX options (or hybrid), since nothing else presumably is liquid enough?

Bill Luby said...

Good comments, all.

To be perfectly honest, I do not believe SPXU has much value as a hedge and hope to put together a post later today that details some of my thinking.

For the record, I also agree with the anonymous commenter that it is big stretch to say that SPXU is having any impact on the VIX. Still, I thought the graphic would be -- at the very least -- provocative.

Cheers,

-Bill

Anonymous said...

I don't see any reason why it should be so. However I think tthat for a major Investment bank it should be fairly easy and cheap to ramp up spx by selling out of money put and calls on spx, thereby pushing vix down, and feeding exuberance.

The Small Fish said...

What about decay? Can you effectively hedge with an intruement that undergoes decay after a few days? it would seem to be that you would have to employ shorting rather than buying long if you wanted to use SPXU and UPRO as hedges.

eyedoc said...

Looks like Obama's trying to spin the GDP report before it gets released tomorrow. You can bet he's seen it, so it sounds as if it's going to be worse than expected. We'll see if my theory is correct or not.

Bill Luby said...

Small Fish,

I think you are correct about the decay factor limiting the window of effectiveness for SPXU as a hedging tool to a few days, perhaps one week at the most.

-Bill

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