Feb 27 (IFR) - Hedge funds have levered up their short plays
on VIX futures to such extreme levels that the market is poised
for a significant short squeeze.
According to the latest available Commitment of Traders data
published by the Commodity Futures Trading Commission, the hedge
fund community is currently net short the CBOE's Volatility
Index (VIX) to the tune of US$85m vega notional via futures
contracts. That level is down slightly from US$108m at the end
In June, that net exposure was zero - and the swing in
exposure means a short squeeze on the VIX is likely if not
"In search of income, hedge funds have been steadily
levering up their positions to short the contango of the VIX
futures curve over the past several months," said Ramon
Verastegui, head of engineering and strategy for the Americas in
the global equity flow group at Societe Generale.
"This short net position is becoming significant, and any
market correction can easily lead into a short-squeeze as hedge
funds look to get out of their positions."
As the VIX shows its first signs of life this year in the
face of political risks in the US and Europe, the potential for
a reversal of hedge fund positioning to exacerbate any
volatility spike resulting from a major event remains a real
The Italian election was the main driver behind a volatility
spike on Monday, but while fears were raised by the event, it
didn't prove enough to trigger the short squeeze.
After breaking 15 for the first time this year at the end of
last week, VIX followed up with a 34% spike on Monday to end the
day at 18.99 as a record 302,278 futures contracts changed
hands. The index was trading below 16 on Wednesday morning.
With the VIX hovering around record lows through the first
two months of 2013, generally between 12 and 14, monetizing the
contango of the curve has been a no-lose situation in the early
part of the year.
But strategies that take a long position in longer-dated
contracts, while shorting near-term expiries, could prove costly
in the event of a volatility spike.
And there are plenty of potential triggers on the horizon.
"It's been our view that there's been too much complacency
for a while now," said Clifford Davis, head of equity
derivatives flow sales for the Americas at BNP Paribas.
"The market seems to be waking up as we've seen a big uptick
in interest for tail hedges over the last week on the S&P 500
and the VIX."
A handful of macro risks still remain, and an impending
short squeeze via the hedge fund community could compound any
subsequent spike. The US government has been scheduled since the
start of this year to implement US$85bn in sequestration cuts on
March 1 and will run up against the expiration of the debt
ceiling later in the month.
"We are facing many headwinds. On one side, the equity
market has reached new heights in the US. On the other side,
from the macro perspective, we still have many potential
catalysts such as the sequestration, unresolved Italian
elections and potential political spillovers that can realize at
anytime," said Verastegui.
"As for magnitude, a short-squeeze can create a 'butterfly
effect' where a minimum impact can amplify into much higher
market volatility spike."
The changes involve extending normal futures plays into
options on VIX futures.
"We've been conditioned by policymakers to believe that
market volatility has been contained," said Edward Tom, global
head of equity derivatives strategy at Credit Suisse.
"The prevalent belief that they will diffuse the impact of
foreseeable shocks via kick-the-can-down-the-road policies has
kept volatility in check this year," Tom said.
"But despite the low vol, skew convexity has increased,
opening the door for so-called higher-moment derivatives trades,
where an investor would use put options on the VIX to fund a
tail hedge against a possible event."
Tom and others have been recommending selling put options to
purchase call option spread trades on front-month VIX futures
contracts as a means of hedging. On Tuesday, options on VIX
futures set an all-time volume record, as 1.4m contracts changed
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