Markets don’t always collapse because of bad news. Sometimes the design of a product is enough – and the right moment.
• Short Volatility Squeeze: When betting on calm markets becomes dangerous
• Volmageddon 2018: The largest daily VIX increase since 1987
• The tipping point: XIV carried its dissolution condition in its prospectus from the start
Short Squeeze vs. Short Volatility Squeeze
Both phenomena follow the same basic logic: Anyone who bets on falling prices is forced by the market to capitulate, thereby reinforcing the very movement that hits them. In the classic short squeeze, short sellers of a stock are forced to buy back when the price rises, thereby driving the price even higher, as in the case of Gamestop 2021. In the short volatility squeeze, on the other hand, it is not an underlying asset that is shorted, but volatility itself, for example via inverse VIX ETPs or the sale of options. If volatility suddenly increases, these positions must be closed or hedged at a loss, which creates selling pressure in the stock market and further fuels volatility. The result is the same: a self-reinforcing chain reaction triggered not by fundamentals but by the mechanics of the positions themselves.
Volmageddon – What happened on February 5, 2018
On Monday, February 5, 2018, the S&P 500 fell 4 percent while the VIX, a measure of implied volatility from stock option prices, jumped 20 points. As the Bank of International Settlements (BIS) explains, that alone would have been explainable, because falling prices have historically been accompanied by increasing volatility. But this day was different: The increase in the VIX that day significantly exceeded what would have been expected based on the historical relationship, making it the largest daily VIX increase since the 1987 stock market crash.
The trigger, as BIS writes, was not in fundamental news, but in the mechanics of the market itself. Since the VIX had already risen since the previous day, market participants knew that both leveraged long and inverse short volatility ETPs would be on the same side of the VIX futures market shortly before the close. Starting around 3:30 p.m., other market participants began pushing VIX futures higher in anticipation of this rebalancing. Due to the mechanical nature of the rebalancing, higher VIX futures prices required even larger purchases by the ETPs, a feedback loop emerged. Transaction data shows volume surged to 115,862 VIX futures contracts, roughly a quarter of the entire market, in a single minute at 4:08 p.m., at massively inflated prices. The value of the inverse volatility ETP XIV subsequently fell by 84 percent and the product was subsequently discontinued.
Stock market spillovers were also clearly visible: VIX futures traders hedging their positions by shorting E-mini futures created additional downward pressure on stock prices. Overall, the S&P 500 fell 4.2 percent on the day, a move of 3.8 standard deviations.
The tipping point
Inverse volatility ETPs like If the VIX rises, the position loses and the ETP must buy VIX futures to restore its target exposure. This is exactly where the structural weakness lies: every purchase pushes the price further, which forces further purchases, as BIS writes. This feedback loop is not the result of irrational behavior, but of the mechanical rebalancing duty itself.
The specific tipping point for XIV was contractually agreed: If there was a daily loss of 80 percent or more, the product was automatically dissolved. The closer XIV got to this threshold, the larger the forced purchases became and the more attractive it became for other market participants to accelerate this process through targeted front-running. On February 5, 2018, this very dynamic led to around a quarter of the entire VIX futures market being traded in a single minute, according to BIS. XIV ultimately lost 84 percent of its value and was discontinued, not because the economic fundamentals had changed, but because designing the product under stress inevitably led to its own destruction.
Markus Maier, editorial team at finanzen.net
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