VIX – Virtual Invitation to eXtinction?

Editor’s Note: This article describes our surmise of what might have precipitated the waterfall declines in the S&P 500 index this month. Putting it plainly, this is our opinion and our opinion only. Even more plainly, opinion is a fancy word for a guess. No one should base any decisions on any opinion in this article or take any action based on or because of it. All decisions and actions should be based on individual circumstances, objectives, risk tolerances and should be discussed with investment advisors.

VIX is the symbol for the Volatility Index, sometimes called the fear index. Broadly speaking, the VIX rises when the volatility (up and down movement) of the prices of the S&P 500 stock index increases.

A high level of VIX suggest a high degree of fear in the stock market and in sedate times, a high degree of fear is used by contrarian investors to suggest a buying opportunity. This is today’s adaptation of Baron Rothschild’s old comment “buy when there is blood on the streets”.

Viewers of  CNBC’s risk-oriented show “Fast Money” will recall that on several occasions this year, Fast Money traders told its viewers to buy stocks when the VIX went to 30. This was because during the past few years, VIX at 30 signaled a near term bottom in stock prices. This advise worked well in July and in August.

But this interpretation of VIX failed totally and destructively in September and October.  The speed and ferocity of the decline in stock prices reached a frenetic level this month and the week of October 6-10 turned out to be the worst week for stock prices in history. The Dow Jones Industrial Average was broke 11,000 ten days ago, broke 10,000 four days ago on Tuesday, broke 9,000 two days ago on Thursday and broke 8,000 momentarily on Friday morning. At the same time, VIX exploded upwards and reached the unheard of level of 75 on Friday (October 10) morning.

Financial Networks and Print Media kept trying to find a logical reason to explain this decline. They finally settled on the fear of a global recession as the main fundamental reason for this decline.

Rubbish, we say. Stocks do not crater in this fashion because of any fundamental reason. Something goes terribly wrong in the plumbing of the stock market to create such “waterfall” type declines. (The term “waterfall” is jargon to describe a very large and very fast decline in a very short period of time.)

In this article, we ask whether the use of VIX based techniques played a critical role in this waterfall?

1987 Revisited
This sort of decline was last seen during the week before the crash of 1987 and culminated in the crash on October 19, 1987.

Does this week’s decline have any parallel to the crash of 1987? We think so.

The key to both 1987 and 2008 crashes is the pursuit of the “holy grail” of Professional Money Managers. This community typically has to stay fully invested all the time, during both up and down markets. This works wonderfully when markets go up but not so well when markets go down. Normal investors can protect themselves by selling stocks when they get nervous. But, Money Managers have learned from experience that this can be a career-ending mistake.

To understand this, recall 1998, another scary period in the stock markets. Russia defaulted, Emerging Markets cratered, Long Term Capital Management blew up. Money Managers who sold stocks in October 1998 and tried to protect their clients missed the upside, when the markets turned violently on a dime and exploded upwards. Managers who raised cash could never catch up with the upwardly exploding markets. Their clients never forgave them for missing the upside and these “conservative” managers experienced serious damage to their careers.

So, Money Managers devoutly seek their holy grail – a technique that enables them protects their portfolios while allowing them to stay fully invested.

In 1987, the Money Manager community believed they had discovered such a technique. They called it “”Portfolio Insurance. The idea was beautifully simple and easily implemented. When their stocks declined in price, Money Managers sold short S&P 500 futures to buy “insurance” against the decline – in other words, as their stocks declined, the value of their “short” futures position increased. The loss in the stocks they owned was offset by the profit in the short futures position (selling short mean selling what you do not own – this position makes money if the futures decline in value).

This technique worked wonderfully as long as the moves were small and brief.  So, more and more Money Managers started using this “Portfolio Insurance” technique.  As more and more managers used this technique, it became less and less useful. Finally, on that day in October 19, 1987, the continuous and accelerated use of this technique resulted in the crash.

Why? Look how this technique worked. When stocks started falling, Money Managers sold S&P 500 futures just as the technique said they should. But, as managers sold S&P 500 futures, the stocks in the S&P 500 went down and the more the stocks went down, more money managers sold more futures creating greater declines in stocks which forced more Money Managers to sell even more futures and so on.

This created a self-perpetuating vicious cycle of stock declines creating declines in futures which led to greater stock declines. This vicious cycle gained momentum and velocity as the day went on. The result was a waterfall decline that was termed as the crash of 1987.

The use of VIX-based Hedges in 2008

In the first 8 months of 2008, the use of VIX-based hedges (VIX Futures, VIX options and VIX swaps – techniques based on quantitative analysis of historical models of VIX behavior), allowed money managers a novel way to protect their stock portfolios. When they became nervous about the markets, the managers could buy VIX futures, buy VIX calls or enter into VIX-based swaps to protect their stock portfolios. The technique works because, as stocks drop, the VIX rises and the loss in stocks is offset with the profits in the VIX hedges.

The use of VIX became increasingly popular in 2008 until it entered the mainstream of hedge funds. We recall that sometime in September,  Dr. John Najarian  (brother of FastMoney’s Pete Najarian and a frequent guest) told viewers that he saw the big guys buying large quantities of VIX Oct 50 calls (a position that makes money if VIX goes up above 50 before October 18, 2008). What a terrific trade idea for Fast Money Viewers! No wonder most active investors watch Fast Money.

But, when Fast Money brings a technique to your attention, you know that the technique is being used by virtually every hedge fund manager and many money managers. 

As in 1987, when a technique is used by everyone it looses its effectiveness and when it is used in large volumes in stressful conditions, it becomes toxic.

Look at the chart of VIX vs. the S&P 500 below and see how this technique worked sedately until August 2008 and then how it exploded in September and October.

                               (Chart of VIX vs. the S&P 500 in yellow – courtesy of  bigcharts)

To fathom this, you need to understand how the use of VIX hedges could create the same vicious cycle that “portfolio insurance” did in 1987. 

The scenario goes something like this – when stocks go down, Managers buy more VIX hedges which make VIX go up which in turn requires the counterparties to sell more S&P 500 futures which makes stocks go down which force the Managers to buy more VIX hedges and so on. 

Such a vicious cycle can create waterfall declines in stocks, the type of large and extremely rapid declines we saw this week in the late afternoon periods. Day after day this week, CNBC’s Dylan Ratigan and Maria Bartiromo (anchors of “Closing Bell” from 3-4 pm) kept expressing awe at the multi-hundred point moves in stock indices that took place in a span of few minutes.

Were these declines a result of the VIX strategies used by hedge funds and money managers? Only the Exchanges can tell us for sure. Eventually, the experts will look back at this period, analyze the data and tell us what really happened.

If our surmise is shown to be valid, perhaps we should rename VIX as a Virtual Invitation to eXtinction of money.

Until we know what really happened, we have told ourselves to look at the fear index with fear. After all, a little bit of fear can be an invitation to courage, extreme fear is rarely so.

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