(Bloomberg) -- While equity volatility is rising once again, this spike is different from the one a month ago.
It all started with a large Cboe Volatility Index options trade put on last week, and the impact of its hedging was another proof that the space gets “broken” when dealers become vulnerable to sharp moves in the gauge, according to Charlie McElligott, the managing director of cross-asset strategy at Nomura Securities International.
Hundreds of thousands of options betting on a VIX jump in the next few weeks changed hands on Friday in the first “massive” such trade since before the August rout, McElligott wrote in a note. The positioning for a spike in market tumult happened as both the S&P 500 Index and Nasdaq 100 Index were solidly up that day.
But with Tuesday’s equity slump, market makers on the other side of the trade had to hastily hedge their book by buying volatility and selling stock-index futures into an already escalating equity decline. That led to a “massive freakout,” McElligott said.
While the VIX rose significantly, it’s the move in what’s known as vol of vol that attracted the attention: The Cboe VVIX Index surged 36 points on Tuesday, the most since February 2018 and way more than it should have given the S&P 500 action. The benchmark equity gauge lost 2.1%, less than on Aug. 5.
“Yesterday’s bizarre market action was predominately a VIX options dealer hedging event,” McElligott said, adding that it impacts more volatility than the wider stock market.
Equities are entering a seasonally challenging period, and a slump in Nvidia Corp. shares on Tuesday only made things worse. What’s more, the market had to contend with synthetic short gamma — positioning that leads to increased selling pressure as the market falls — from products such as leveraged exchange-traded funds. Nomura estimated almost $18.6 billion of rebalancing sell flows from such securities toward the end of the trading day.
For their part, the VIX call spreads bought on Friday for 25 cents each and sold on Tuesday for 60 cents made a “tidy little profit,” McElligott said. The investor or investors could have gained more than $12 million, according to Bloomberg calculations.
Also read: Mystery Option Buyer Nets Fast $12 Million Gain on Stock Slide
While the unwinding of the VIX trade eases the downside pressure for equities, “we admittedly remain priced for tension,” McElligott concluded.
Strategists at Tier 1 Alpha are skeptical the volatility-suppressing flows that have helped the rebound since the August low will continue through the rest of the month.
“There is still a notable amount of instability being priced into the market,” they said, noting that the cost of hedging against equity declines and volatility remain elevated.
(Updates from first paragraph to add more context)
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