How volatile trading in the Volatility Index has made things a lot more....well, volatile.

Friday 18th September 2015

 

Ref : "Analysts add to ETF volatility warnings" , The Financial Times, p.28

VIX (full name : Chicago Board Options Exchange Volatility Index) is a measure of the implied volatility of S&P 500 Index Options  --  and therefore, in practical terms, of US stock markets in general. High volatility can of course occur in markets on the rise, but is more usually seen in (and in people's minds is certainly associated with) falling markets. Consequently, VIX has come to be known as the "Fear Index".

 VIX is tradeable  --  you can buy and sell it, most usually through futures and options, and can be used to hedge share portfolios. Since high volatility is generally viewed as a negative, you might for example (if you take the view that shares are likely to fall)  Buy VIX in the expectation that what you make on the rise in volatility will roughly compensate you for the fall in value of your stocks.

Now, certain ETFs (Exchange Traded Funds) that use leverage to magnify investor returns are under fire for exaggerating (upward) moves in the VIX, which undermines confidence and has contributed to downward moves in the underlying stocks, and also for increasing the volatility of the Volatility Index itself  --  not a welcome course of events for the responsible investor. In particular, the critics had August in mind when VIX spiked to its highest level since 2011 as stock markets tumbled in response to concerns about China and the wider global economy.

But what exactly might these ETFs be guilty of ? Here's how it might work :

 To quote the FT :

"When someone invests $100 in an ETF that offers twice the returns of the VIX futures index, the ETF provider buys $200 of futures. If the price goes up 10% the investor receives 20% (of his investment) back, or $20. The investment is now worth $120 and the ETF is worth $220, so at the end of the day it has to buy a further $20 of futures to maintain that (2 to 1) level of leverage for the next day.

"ETF providers therefore buy as prices rise and sell as prices fall, which critics say exacerbates market movements...."

 Predictably enough, the ETFs in question deny that what they might be doing in VIX futures has much of an impact on the VIX itself, and therefore by extension on the underlying market. Sounds a little thin, particularly when you consider what else might be going on towards the close of the trading day. The amount that the ETFs need to rebalance is publicly disclosed. "If people know someone has to buy in large size at the end of the day, they will simply buy the contracts ahead of them".

Thus, to revert to the repetitive theme, the exaggeration is exaggerated.

 

Oh yes, that Fed thing ......

So, no action after all. Whether you believe this was a good decision or a bad one, you surely won't welcome the fact that the interminable speculation on the timing of the next hike is set to go on... and on. Pretty much on a daily basis, every scrap of economic data will be scrutinised for its impact on the rate debate.

 

Actually, US data looks to have taken something of a back seat in the Fed's thinking, apart that is from inflation (or the lack of it). If one word summed up the thrust of Chairwoman Yellen's statement, it was "Global". Clearly, the board (almost in its entirety) took full account of the possible dangers of a hike to a fragile global economy, and therefore ultimately to the US itself. In effect, fulfilling its domestic mandate by looking globally.

 

The immediate results of the "NO CHANGE" call : Bonds up (yields down), dollar down. Stocks are mixed .... history shows that a hike need not be bad for stock markets, and certainly the lack of action does no favours for bank shares, for example.

 

The statement can be viewed as being on the "doveish" side, which has prompted a good number to postpone their estimate on the timing of the hike into next year. We might be stuck with this for a good while yet.