Inside the VIX Engine of Destruction

Volatility derivatives are being cited as a technical explanation for the equity market spasm otherwise “without a cause.” We think this small market presents no systemic risk in and of itself. But we offer a theory for how it does set up runaway trading dynamics that transmit contagion from bets on the volatility of stock indices into the stock indices themselves. We theorize that the hedging strategies of volatility dealers – who until now faced a lopsided market in which most participants wanted to be short volatility – have all the same positive-feedback loops as “portfolio insurance.” So do “target-volatility” and “risk parity” strategies. All are subject to predatory “bag runs” by front-runners, who deliberately make matters worse. There is no natural end-point, so we expect further oscillations, damping down over the coming days. We see this cause-free scare a test of the revival of animal spirits and risk tolerance.