A Map To The Underworld: $2 Trillion Of Volatility Trades

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As the value of the VIX contracts being shorted increases, the fund also becomes "more short" the VIX, a phenomenon which must be offset by reducing short holdings, which once again involves buying underlying VIX futures contracts.

Products directly linked to the VIX may manage as much as $8 billion, according to SocGen estimates.

The VelocityShares note was created to bet against wild gyrations in the market, measured by the VIX, Wall Street's so-called "fear gauge".

"The day started out fairly orderly, but somehow it took a turn for a worse, and then panic set in", Randy Frederick, vice president of trading and derivatives for Charles Schwab in Austin, Texas. One of the most popular time frames using RSI is the 14-day. Bets against volatility had doubled in 2017.

The VIX instruments derive their returns based on futures contracts, which also explains why their meltdown occurred at the end of futures trading. "Imagine you are a trader, it's 2:30 p.m. and VIX futures are up about 3 points - you know what is going to happen at the close". So when volatility spiked by a record 116% on Monday, the funds plummeted.

And amid the market turmoil overnight, the S&P500 VIX Index jumped by more than 100% to close at a reading of 37.32.

The notional value of contracts on such products traded on Friday was six times the daily average for the previous year, said the head of European equity market trading strategy at a bank in London.

Over-the-counter options trading in US equities reached about $2.7 trillion in notional amounts outstanding in the first half of previous year, according to data from the Bank for International Settlements.

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Meanwhile, ProShares will continue to operate SVXY, which is structured as an ETF.

The repercussions have been severe for some funds. According to the NYSE Trader alerts page, the Proshares Short VIX Short-Term Futures ETF (SVXY) even had trading price adjustments and its shares were halted.

Credit Suisse announced the event acceleration of its XIV ETNs on Tuesday morning. More recently, Societe Generale's head of global asset allocation, Alain Bokobza, compared the continued VIX shorting by hedge funds to "dancing on the rim of a volcano".

Highly leveraged yield-seeking strategies in high yield bonds or commodity-linked currencies that have mushroomed in the aftermath of the 2008 global financial crisis are likely to come under pressure the longer volatility stays high.

Derivatives markets indicated, however, that the spike in volatility of the past few days would not be sustained. More surprising still, the VIX index recorded "the highest growth spike in its history, causing some funds to suffer heavy losses and some firms to put their fund into liquidation, due to excessive leverage", as Damian Bernardi (Diaman Sicav) said.

The "buy stocks, sell volatility" was working till last week.

The impact of the market sell-off on other asset classes has been fairly muted though various gauges have risen reflecting broader uncertainty around markets in the short term.