How Two Tiny Volatility Products Helped Fuel a Sudden Stock Slump | Hacker News Reader

How Two Tiny Volatility Products Helped Fuel a Sudden Stock Slump

bloomberg.com

81 pointspaulpauper44 comments

Sure, this is an article from this year but it certainly needs something like a [FEBRUARY] tag on the title given they aren't talking about the recent slump.

Former vol trader here.

This is an old article but the dynamic is always applicable. Your main issue is that anything that isn't statically replicating, ie simply holding a constant basket of whatever it's supposed to track, needs to rebalance. The bigger the deviation the more unfavourable that is. What vol traders call negative gamma or convexity if you are from the fixed income world. The problem is you are pushing the wrong way on prices when you need to rebalance.

The thing is the markets have been in a very low vol environment for a long time, possibly ending in the last couple of months. We'll see. But until then it was quite a popular trade to be short options.

You can Google optionsellers.com to see what happens when things go wrong.

It sounds like this applies to broad total market index funds too. I still feel like I don't know shit about the stock market so forgive me if that's a 101 question.

If I am an index broadly tracking the market, weighting each stock by market cap or whatever, then if it goes up, I have to buy more. If it goes down, I have to sell. Is that right? Is the that kind of rebalancing you're talking about?

It sounds like a positive feedback loop that could run away. Stock X goes down, forcing some index to sell it, forcing it further down, forcing them to sell more, etc.

If you’re keeping a balanced portfolio of assets and the price of one goes up, you sell to rebalance, not buy.

Is that because the underlying indeces are defined as each asset being a fixed percentage of the whole? Like, hypothetically, the S&P 500 would define MSFT as 1% of the index so if MSFT goes up then the fund would have to sell it to keep it from being more than 1% of the total holdings?

For what it's worth, the S&P 500 uses float-adjusted capitalization weighting.

https://en.m.wikipedia.org/wiki/Capitalization-weighted_inde...

After reading more about stock index funds I'm more confused how their rebalancing works. I now understand that the S&P 500 index is basically the total market cap of the free float of the 500 companies combined. I just don't see why a tracking fund would have to rebalance at all. If you own the 500 stocks at the right proportion it should stay balanced as each company's market cap grows or shrinks relative to all the other companies. The only time you would have to rebalance is when companies are added or removed from the index.

A market-cap weighted tracking fund still has to rebalance if one of the companies issues new shares, or buys some back, as well. But that's a relatively unusual situation (like dozens of events per year, not daily).

It seems like you mostly have a good understanding of how it works. A tracking fund would have to rebalance in the advent of a company issuing or buying back shares, when there is a corporate action like a spinoff or merger, or when a company is added or removed from the index.

Additionally, you have the reality that every day, investors buy and sell that fund. The tracking fund, therefore, has to liquidate or buy new holdings to match the NAV (net asset value) as shares are created or redeemed. This is where tracking funds will vary in their performance as some ETF providers might be a lot worse at matching up inflows and outflows.

A couple of things:

1) A fair few of those 500 stocks are not very liquid, you'll lose a fortune chasing the shares.

2) Think about what happens if you want to provide exposure that isn't 1x the index.

3) What happens when there's a replacement?

4) What about things that aren't statically replicable?

No. The index fund has a fixed amount of money. It can't keep buying when the stocks go up.

If I'm a seller of a put option (sort of "price insurance") on the index, and want to hedge my exposure, then every time the price goes down, I have to short the stock. Every time the price goes up, I have to buy the stock.

This is largely seen as the cause of the 1987 stock market crash - a small correction caused portfolio insurers to start selling more, which made the market go down, which made them sell even more, etc.

https://realmoney.thestreet.com/articles/10/21/2017/real-cau...

I’ve looked and not found the daily volume for the entire market before now. Is there a simple way to look that up? Or even other time frames? All I see are volumes for particular stocks.

Thank you for your insight! Iirc, low volume is consistent with elevated prices across the board. And, of course, corrections are to be expected.

pretty sure he means vol==volatility here

A lot of people were wondering why the XVI and SVXY products collapsed so quickly even though spot volatility was not up that much and SVXY and XV were only down 15% for the day yet were down 80% the following day.

The answer is kinda subtle and most sources don't explain it well. The reason is, volatility futures trade until 4:15 but the market closes at 4:00. So this means SVXY and XIV reset at 4:15 instead of 4:00. This means the 80% termination clause is not based on the market close but actually based on the 4:15 price of volatility futures close. In the after hours in that fateful 15 minutes, the futures saw a massive surge and crossed the 80% liquidation threshold. After 4:15, SVXY and XV began to dive because at that point they were dead, but the decline was initially gradual because most people did not realize what had happened. That 15 minutes is what made all of the difference.

Well, the VIX futures trade well after 4:15. What I don't understand is that the collapse didn't happen just in the last 15min after the session but progressively up to a an hour or two after if I remember. The underlying S&P VIX strategy seems to be using a fixing as of 4:15 indeed per the S&P documentation [1].

In any case, setting the fixing in the middle of an illiquid market was a moronic decision and if I had been burned by this, that would be my potential avenue for litigation.

Also I wonder how much of this short squeeze was amplified by other market participants who anticipated this event could happen. Some trading desks made a killing that day.

[1] https://us.spindices.com/indices/strategy/sp-500-vix-short-t...

The fair value of SVXY at 4:15 using the usual formulas was around $4, but it was trading around $70 at that time. However a lot of that price movement was due to essentially flash-crash type movement in the last minute of trading in the VIX futures. This introduced two problems for potential arbitrageurs. For XIV, the problem was that it was possible that CFE would bust trades at the extreme price levels, leading to a revised closing price and corresponding payout on the ETN. For SVXY, the problem was that it was possible that the extreme conditions had caused the fund managers to deviate from their target position, and thus hadn't actually lost as much money as they were supposed to based on their stated objectives. CFE never busted trades, but SVXY did end up deviating significantly from their target position, in the form of not taking off as much risk as they should have at 4:15. They ended up working the remaining order slowly through the overnight session and the following morning until about 10 am the next day. They got better prices on the make up hedge than the 4:15 price, which is why it opened the next day around $11 (which was a fair price) instead of $4. They made an extra $7/share by deviating from their objective. It could easily have been much bigger, and speculation about how much they hedged and at what prices is, in my opinion, why the price movement wasn't immediate.

Note this is from 11 months ago, February 2018.

As a former equity vol trader turned software engineer, my lessons:

* derivatives are a leaky abstraction. Understand how the underlying securities work all the way down

* read the docs!

Why did you make that change? Very interesting.

As a former software engineer turned algorithmic commodities trader, my lessons:

* The VIX(futures contract) is the most accurate pulse of the equity futures market I have seen.

* The price of the VIX is no more important intra-day than the depth of the VIX's inside bid/ask.

* When VIX depth adjusts, so do equity future prices, over the course of 5-10 seconds.

* Be fast, I mean really fast. Or better, program your trading platform to be fast so you don't have to.

Some questions:

Does this mean the majority hedges with VIX futures and the rest is just arbitrage?

Where are you getting depth VIX data (is it available at IB)?

Is there historic data available somewhere to study this?

For your first question: I don't know, but I speculate the majority is hedging.

Second: I get my data from CQG, but you can also get the same feeds from IB. The specific exchange you need for VIX is "CBOE"(http://www.cboe.com/vix). ampfutures.com is a broker that offers this, but there are many(possibly better) others that offer it as well.

Third: Historical data for the depth isn't available from any broker I have used. That said - I'm a retail guy, and there may be options for institutional traders that I'm unaware of. As a retail guy you can buy this data though, just not from a broker. IQFeed offers it(6mo back for market data, and 6mo for 1-tick resolution data) - but it's expensive. The last quote they gave me was $1350/month for CME and CBOE tick-by-tick resolution with 10 levels of depth.

Which broker are you using for execution? IB? Curious if there's a better one for futures/futures options since I've started getting into them recently on IB.

If it's not revealing too much, what kind of stop loss distances are you generally using in your strategies (ticks)?

Are you using any kind of "walk forward optimization" in your testing?

You mention in another comment that you intentionally do not trade during _expected_ market volatility. Do you have parameters for sitting on the sidelines during _unexpected_ volatility, e.g., VIX over certain threshold, time since last Trump tweet according to Twitter's firehose API (serious), etc.?

For execution I use Tradovate(which uses Dorman Clearing LLC). They have low commissions, and offer a membership to reduce commissions to $0(you still have to pay exchange costs though). Before Tradovate, I had used AMP for execution, but eventually left them over the cost of commissions.

I use a 8 tick stop and a variable profit target(a result of weekly re-optimizing). Last week the target was 24, and the week before the target was 16. The stop loss value I don't like to change, and 8 ticks has been enough for "good" entries. If I need more than 8 ticks, then I believe the entry price is my mistake - not the stop loss value.

I perform optimization every Friday, using that week as the training data to find the "best" thresholds for changes in depth before signaling a trade. Then the next Monday, I'll use those new values all week(and repeat the cycle that Friday). Basically - re-optimize every week. It's not a lot of work, just input the starting date, click optimize, and wait ~20m for the outputs. I like to keep track of each week's settings, with the plan to one day review their changes, and try to reason about why those changes happened(I haven't done this yet though, it's one of those one-day-I-ought-to ideas).

I don't have any algorithm parameters for unexpected volatility, the closest I have is a condition that turns the automatic entries off if the nearest 4 bids and asks(examining a total of 8 prices) contain more than 4 ticks of spread(no bids or asks), and both sides limit orders sum to less than 30. I didn't add that until sometime around Valentine's day 2018(that was not a good couple-of-days). When that happens, it disables entries and sends me an SMS.

Thanks for the answers!

What blogs/news do you follow for commodity trading? Got any favorite book/papers for algorithmic commodities trading?

I used to follow a lot, and drank a bunch of the kool-aid from Jigsaw Trading. Now I read very little, other than the economic calendar for US/Canada/Europe each morning. I'm looking for high volatility events(such as FOMC, GDP, etc) so I can make sure I am not in the market when they take place.

I haven't read any books about algorithmic trading(but I've read a ton about trading in general...favorite is Mark Douglas's 'Trading in the Zone'). Most of my introduction to algorithmic trading came from a trading platform(Multicharts.NET). I wasn't a .NET programmer specifically, but they include the source code for all indicators/signals that ship with the product. This made it really easy to tinker with automated trading signals, and I don't think I would have ever attempted it without that exposure.

Also, you didn't ask for this piece of advice...but: be very cautious of tips from any blog or news outlet. The people producing those are under tremendous pressure to produce "something", even when there isn't any insight to be had for a day/week/event/etc. They will produce something anyway, relevance be damned. If you needed some help/ideas, you would be better served joining a live trading group. Many of these are free, and they give you a chance to listen(and speak) to other traders, all trading at the same time, usually with the same instruments. I learned some things from GPI Trading Group(http://www.gpitradinggroup.com/) that saved me a lot of time and headache. They are focused on the ZB(bond futures, not equities), but back at that time so was I. I got a lot of feedback from their members about my indicators and automated signals I was working on, and much of it was invaluable.

> The VIX(futures contract) is the most accurate pulse of the equity futures market I have seen.

more accurate than computing via underlying futures?

.. VIX itself is a summation, no?

https://www.cboe.com/micro/vix/vixwhite.pdf

It's supposed to be, but I stare at it every day for 2 hours(for years)...and it just doesn't work out that way. Half the time moves initiate in the VIX, and only moments later does price move in equities.

Example: this morning at the open, the VIX rose 7 ticks in the first 20 seconds - there was almost no volume to the opening move(on the VIX), and price(NQ) was kicked down 20 points. When the NQ was at this bottom, the inside ask for the VIX changed from 150-ish to 700 - the NQ price moved back up 20 points, but the VIX did not move. The only thing that changed was the depth. Now the NQ is right back at the open...that same 700 ask faded back to 100-200, and the price dropped back another 20 points. Keep in mind, this is the first 5 minutes of the open. It doesn't get more chaotic or random than that period of time. However, as chaotic and random as it might seem, it's like this "most" days(say, 7 out of 10).

One of the large reasons that instruments(like the ES, NQ, or VIX) don't behave the way the way their prospectus might indicate...is humans. Another example, the NQ is supposed to reflect the Nasdaq 100 basket of stocks, weighted appropriately...yet it does not. There is a whole school of trading around "program trading", which is automated trading to fade price movements when this imbalance occurs. If the prospectus is to be believed, this imbalance should never occur. Human beings are the answer: a fund manager has a gut feeling(or some technical analysis, or signal) that equities will move up, so he shorts the VIX for 2,500 contracts, which will absolutely move equities up, at least temporarily. It's not the rules or defined behavior of either instrument - it is the intent of someone with enough margin to execute a 2,500 contract trade. That person(and persons like him/her) are the ones controlling those instruments - not an arbitrary set of rules, or the formula laid out in the instrument's prospectus.

After saying all that...also realize a lot of this is truly random. The moment in time that Trader Joe and Trader Bob both kick off 2,500(or 10,000 for that matter) contract trades is not known by anyone but those humans. So to them, it's not random, but to hundreds of thousands of other market participants, it's random as hell, and causes a lot of "whoah man! did you see that!?" moments. Those pesky humans get in the way of everything :)

From your experience, would you say the VIX futures are useful for anything other than traders taking chunks off the bid or ask moving the equities a few seconds later?

Oh certainly yes it is, but that's just not my use-case(anymore). In the past(when I had longer-lasting positions), the VIX was a useful indicator of "is this move real, or not?". Typically, if all 3 of the major equities(NQ,ES,YM) move in tandem over a 5-30s period, and the VIX inversely matches their movement - then that was my entry signal. When the VIX doesn't match, prices tended to return to their starting point moments later. If you speculate as to "why did the prices snap back?", my best guess was it was the result of profit taking or bad positions puking.

My current use of the VIX is more short-term. Over time, I found ultra-short-term positions worked out the best for me(in terms of profitability, stress, and opportunities per day - stress was #1).

Hmm that is interesting, would you consider yourself a high frequency trader?

The article is from February but it is worth studying the headline which puts the problem on "two tiny" whatever. Looking back the market was around a top and was struggling to move higher. Not a tiny issue more a major top.

Lesson: Study headlines for wishful thinking and draw conclusions.

Why a Feb 2018 article now?

It's a postmortem of the mini-crash we saw in February. No one was expecting it, and it happened very fast. One day the Nasdaq futures are trading at 7100, the next day they are at 6100. Moves of 100 points(a whole day's worth of movement) were happening in 15-20 seconds. Just for some context, 100 points(on the Nasdaq) is $2,000 gained or lost, using the minimum size you can trade.

[February], not the recent slump.

I think the entire VIX formula should be restudied as the options market it has been based on is very different now

The SPX index options and SPY ETF options now have 20 options series trading at once at any given point in time.

There is a front series expiring every single day.

This is very different from 1993 when VIX started or the aughts or even last year.

The volatility curve is front loaded by greed, but when opex was only quarterly or monthly, this pile up could more accurately accumulate into the VIX fear guage that we know and have studied comprehensively

Now with “fear” diluted amongst so many options contracts, I really think this should all be reevaluated. The VIX index and VIX futures and VIX futures options and VIX ETFs based on selections of VIX futures all rely on the trading activity of SPX options, and this formula doesnt have the same inputs anymore

Although there are a lot more options nowdays(heh), I'm pretty sure that the VIX only looks at implied volatility in options ~30 days to expiry. So the new, short term options do not factor into its calculation.

> I'm pretty sure that the VIX only looks at implied volatility in options ~30 days to expiry.

even then, this factors into the point. Implied volatility is just how high over the theoretical price of the option people bid. If the greediest speculators aren't bidding those up anymore, and instead of piling into nearer term options expiring every day, then the ~30 day options aren't reflecting the same sentiment.

The VIX index is the average implied volatility of a theoretical set of options trading 30 days out by interpolating the implied vols of a bunch of options. However, what is being discussed here is VIX FUTURES. The price of a VIX futures contract is whatever clears the market based on demand and supply not some calculation (the prices of the options used for the VIX calculation are also whatever clears the market, not something off some ideal volatility surface but that is besides the point). More options, less options or whatever don't make any difference.

While VIX futures do cash settle to the special opening quotation of the VIX on expiration day, and while the correlation between the VIX index level and the futures is quite high, they don't necessarily move in lock step or even necessarily in the same direction.

While models that tell you what the theoretical price of something is are great at potentially identifying situations where there are mispricings among assets to each other, any mental model where the price of an asset is based on some theoretical calculation is dangerous when trading. The prices of traded things are based purely on demand and supply.

The original VIX used to to be that. But for some time now (approx 2009) it's been a synthetic variance swap made up of a weighted sum of the "bunch of options" (weighted by square of the strike). The huge advantage that this makes over an actual implied vol is that it becomes replicable. And it's close enough to being the "fear index" of the popular press.

> I think the entire VIX formula should be restudied

https://www.cboe.com/micro/vix/vixwhite.pdf

actual forumula is time agnostic; VIX itself is an application of formula to particular inputs

> The VIX index and VIX futures and VIX futures options and VIX ETFs based on selections of VIX futures all rely on the trading activity of SPX options, and this formula doesnt have the same inputs anymore

from above link:

"In addition to the VIX Index, Cboe calculates several other broad market volatility indexes including the Cboe Short- Term Volatility Index (VXST SM ) - which reflects 9-day expected volatility of the S&P 500 Index, the Cboe S&P 500® 3-Month Volatility Index (VXV SM ) and the Cboe S&P 500® 6-Month Volatility Index (VXMT SM ). Cboe also calculates the Nasdaq-100® Volatility Index (VXN SM ), Cboe DJIA® Volatility Index (VXD SM ) and the Cboe Russell 2000® Volatility Index (RVX SM ). Currently, RVX futures are listed on CFE and RVX options trade on Cboe. "

but yes, agree, perhaps one should rely on the VIX number itself less readily..

My point is that the inputs don't gauge market fear, and that should be restudied.

Market fear is just the summation of spreads and implied volatility of the some of the index's options contracts, but if all the liquidity in any series has been diluted amongst having more series then you aren't going to get the same results or indication of market sentiment in the VIX number.

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