Regular readers are aware of ShadowCap’s currently bearish slant toward risk assets and bullish outlook on the US Dollar (at least for the short- to intermediate-term). Volatility is a great way to play these outlooks, as prices decline into illiquid market environments. But even besides asset declines, going long vol has other attractive variables that have finally started to come out of the woodwork.
The decline in marginal liquidity provisioning from quant funds has been well-documented by blogs like Zero Hedge since last year, and is obvious when market-neutral index performances are considered. This has led to an illiquid market landscape that is increasingly dominated by other liquidity provisioners, such as Goldman Sachs principal program trading.
Additionally, as the market continued the fall-winter 2008 decline into February and March 2009, many dealers’ equity derivatives portfolios were net-short bullish gamma as a consequence of delta hedging in a market declining at a rapid pace. As the market reversed in early March and began rallying, these derivative books were forced to delta hedge by going long the underlying. With delevaging quants, the negative convexity of delta hedging equity derivatives books led to a highly momentum-based market environment. This eventually led to dynamic prop strategies to essentially chase momentum, furthering the positive-feedback loop.
Like the portfolio insurance ubiquitously pervasive back in 1987, delta hedging is a form of dynamic portfolio hedging that inherently chases momentum. The risk of dynamic hedgers is statistical: fat tails lead to massive positive-feedback unwinds; and with increasing reflexivity, especially in equity cash markets relative to the listed and OTC derivatives markets they hedge, a sharp move up in a market environment like early March 2009’s leads to delta hedgers simultaneously causing and chasing rising markets in of the ultimate negative convexity phenomena.
Market-neutrals, as measured by the Highbridge Statistical Market Neutral Class A (HSKAX), have risen substantially in January, marking a possible end to the massive quant prop delta hedging that drove equity cash demand in 2009. If that is the case, and 1987 is an appropriate analogue, volatility is set to surge as assets decline in tandem with each other. Given the Treasury’s desperate funding mismatches, and the rush into USD and Tsys that occurs with asset declines (particularly after USD-funded carry trades across all risk asset classes driving demand), one could argue that the US government and Federal Reserve are incentivized for such an occurrence. Not to say they will cause or catalyze it, but “don’t fight the Fed” is a mantra I take quite seriously.
The VIX spent the majority of the second half of 2009 trading under 25. With such low volatility, demand for equity indices and single names from delta hedging clearly diminished into year-end, though many of the momo strategies essentially chasing market chasers (dynamic hedging dealers) probably continued buying.
We are now at a turning point where the USD is rallying, risk assets (including equities) are selling off, and vol is increasing. The potential for volatility expansion is quite large, given today’s liquidity landscape and the imminent unwind of the positive-feedback loop from delta-hedging short-bullish gamma books into a statistically significant rallying market.
Indeed, vanilla money has chased the delta hedging (out of necessity), as signified in the below graphs from Sentiment Trader. Crowded trades of this nature lead to explosive positive-feedback unwinds. Essentially the entire equity universe is caught in a momo trade chasing a demand driver that is now reversing. This should increase vol.
In addition, as Richard Whalen of Institutional Risk Analytics suggests in a recent article, the Fed’s acquisition of duration risk with its MBS purchases has suppressed market volatility by masking the negativity of OAS spreads net of Fed asset purchases. When the shoe drops, a rush to hedge may prove the VIX at current levels to be under-representative of current prevailing risk as well as undervalued.
The VXX ETF isn’t the best proxy for the VIX, but it is a nice trading vehicle, especially from a chartists point of view. Still in its declining channel, but a possible bull flag is developing. Most likely will be going long around $32.