The Snowballing Power of the VIX, Wall Street’s Fear Index

Created to track expectations of volatility, it has spawned a giant trading ecosystem that could magnify losses when turbulence hits.

By Asjylyn Loder and Gunjan Banerji
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Retail investor Jason Miller at his apartment building in Boca Raton, Fla., has been shorting the VIX. Photo: Scott McIntyre for The Wall Street Journal


Wall Street’s “fear gauge” has neared all-time lows this year. That hasn’t stopped retail investor Jason Miller from making a nice chunk of change betting it will go even lower.

The Boca Raton, Fla., day trader says he has made $53,000 since the start of the year by effectively shorting the CBOE Volatility Index, nicknamed the VIX. That includes a white-knuckle day on May 17, when the VIX spiked 46% following reports that President Donald Trump had pressured former FBI Director James Comey to drop an investigation into former National Security Advisor Michael Flynn.

As the 40-year-old Mr. Miller recalls, he rode out the storm, confident the market would revert to its torpid ways—which it did. “One person’s fear is another person’s opportunity,” says Mr. Miller.

Volatility—or the lack of it—has become the central obsession of the markets as the S&P 500 trades around its all-time high. Invented 24 years ago as a way to warn investors of an imminent crash, the VIX has morphed into a giant casino of its own.



Volatility trading has wormed its way into many corners of the investing universe, including insurance products that guarantee retirement income and mutual funds that try to avoid the worst declines. Once the obscure province of academics and derivatives experts, volatility is now traded by would-be retirees alongside the most sophisticated hedge funds in the world.

Even investors who have never heard of the VIX are exposed to its gyrations. There’s an estimated $200 billion in so-called “volatility control” funds that use the VIX to decide whether to buy or sell stocks. “Tail risk” strategies, designed to steer clear of sudden slumps, often rely on it. Pensions such as the San Bernardino County Employees’ Retirement Association have profited from bets the VIX would fall. Asset managers including AllianceBernstein incorporate volatility into retirement-date savings funds, adjusting stock exposure based on the severity of market swings. And insurance giant AIG sells annuities with fees that rise along with the VIX.

Lately, the VIX has been signaling a near-complete absence of fear, and the preternatural calm is making some people nervous. Opinion is divided on whether it is a bullish signal for stocks or a worrying sign of complacency. After all, the VIX also approached a record low in early 2007, just before the subprime crisis began unspooling. In recent days the VIX nudged higher, rising more than 10%, as technology stocks fell.

Some analysts see low volatility as a sign of increased efficiency, where shocks are more quickly absorbed by the markets. Others credit the growth of passive investing with overriding the herd mentality that exacerbates panicked selling. And yet another theory claims VIX trading itself has smoothed the market’s jagged edges by allowing traders to easily offset risks.

Whatever the reason, becalmed stock markets have become a feature of the postcrisis world. Central bankers have lulled investors with record-low interest rates and flooded the market with cash. Even though the Federal Reserve is slowly withdrawing those supports, stocks have lost none of their appeal, notching new highs despite U.S. political turmoil.



This leads to the VIX paradox: The lack of fear scares some investors who say bloated stock prices portend a painful reckoning when monetary policy tightens.

“They’re not adding to market stability. They’re just building a bigger bomb,” says Tom Chadwick, a New Hampshire financial adviser who uses VIX options to help protect his clients’ portfolios from downturns. He says the Fed’s policies have kept volatility artificially low for so long that the speed of any reversal will be more severe. “When this goes, you’re going to see the mushroom cloud from Saturn.”

The VIX was conceived after the Black Monday crash in 1987, when the market fell 23% in a single day. The measure used stock-market bets, known as options, to gauge expectations for the speed and severity of market moves, or what traders call volatility. Options prices rise and fall based on the perceived odds of a payoff, akin to the way home insurance costs more on a hurricane-plagued coast than in an untroubled inland suburb.

Unlike home insurance, options prices fluctuate constantly as traders react to news and reassess their risks. Those prices feed into the VIX. The CBOE launched the original index in 1993, and it quickly became a staple of the financial press.

It took Wall Street another decade to figure out the VIX wasn’t just a market weather vane but also a potential gold mine. In the summer of 2002, newly minted billionaire Mark Cuban called Goldman Sachs Group Inc. looking for a way to protect his fortune from a crash. Because the VIX typically rises when stocks fall, he wanted to use it as insurance. But there was no way to trade it.

Devesh Shah, the Goldman trader who fielded the call, says he instead offered him an arcane derivative called a “variance swap,” but Mr. Cuban wasn’t interested.

Lamenting the lost opportunity, Mr. Shah met up with Sandy Rattray, a Goldman colleague and erstwhile indexing buff with a knack for packaging investment products. What if, the pair speculated, they could tap the VIX brand and reformulate the index based on their esoteric swaps?

“The world wanted to drink Coca-Cola , ” says Mr. Shah, who retired from Goldman as a partner in 2011. “They didn’t want the white label.”

These were the heady days after financial deregulation, and Wall Street was busily securitizing everything from weather reports to bundles of sliced-and-diced mortgages. Turning the VIX into something tradable was nothing more than a math problem, says Mr. Rattray.

The pair rewrote the VIX formula, expanding it to a larger universe of stock-market bets and making it possible to create a tradable futures contract. Their equation synthesizes thousands of trades and distills them all into a single number meant to represent the collective expectations for the market. When the VIX is at its current level of around 10, it implies that traders believe the S&P 500 will move by an average of less than 1% a day during the next 30 days.

The more stocks move, the higher the VIX goes. Since the market typically falls much more sharply than it rises, the VIX tends to surge when the market crashes—hence its potential as insurance.

Messrs. Shah and Rattray handed their invention to CBOE Holdings Inc., the owner of the VIX trademark. Neither had any idea that their brainchild would transform the markets for years to come.

“I didn’t realize how big it would be,” says Mr. Rattray, who is now the chief investment officer for Man Group PLC, an $89 billion hedge fund.

The formula allowed the CBOE to cash in its marquee index. The exchange launched VIX futures in 2004, and VIX options two years later. The firm billed VIX trading as a new risk-management tool, banking on the same appeal that had drawn Mr. Cuban. Trading grew steadily, but slowly.

Then the financial crisis hit, serving up a huge marketing opportunity. Amid an economic tailspin akin to the Great Depression, surging unemployment, and more than $5 trillion erased from the S&P 500, the only thing rising in the U.S. was the VIX, which topped 80 in late 2008. Who wouldn’t pay just a little bit more to protect their nest egg from the wipeout?

At Barclays PLC, a farsighted few realized access was a big problem. Trading futures and options was too complicated and costly for many investors. The bank instead devised a product that tracks VIX contracts but trades on an exchange just like any a corporate stock. Suddenly anyone with a brokerage account could trade like the pros. The Barclays iPath S&P 500 VIX Short-Term Futures ETN launched in January 2009, just months before the S&P 500 hit a 12-year low.

VIX trading exploded. Terrified investors piled into Barclays’s new product and similar ones that followed, desperate for anything that might help them repair their dented fortunes.

“I think of it as the great democratization of volatility,” says Bill Speth, vice president of research and product development at CBOE. “Investors who never would have opened a futures account or traded an option could and did trade these exchange-traded products.”

Amid the panic, investors were willing to pay to insure their portfolios. The costs would be a drag in bull markets, but looked like a small price to pay in the immediate wake of the crisis.

“It was the Wild West,” says Bill Luby, who quit a 20-year consulting career in 2005 to become a full-time trader. “If you knew the landscape, there was a lot of money to be made.”

Trading the VIX, however, is a lot different from watching it on TV, and its idiosyncrasies left some investors feeling burned. No trading strategy can exactly replicate the VIX index, and traders rely on proxies like futures and options, which can veer widely from the VIX itself.

VIX exchange-traded products are especially susceptible to this divergence because of the peculiar structure of VIX futures. Uncertainty increases with time, and the further away an anticipated downturn is, the more expensive it is to insure against. That means VIX futures for this month are typically less expensive than next month’s contracts, which are less expensive than the month after that, and so on.

Some of the most popular exchange-traded products invest in a combination of this month’s VIX futures and next month’s. To maintain their exposure, they sell the contracts that are nearing expiration and buy contracts for the following month. Put simply, they buy high and sell low almost every day, steadily bleeding money. A share of the original Barclays product, bought at its January 2009 debut, would be nearly worthless today.

This decay is difficult to comprehend, even for sophisticated investors, and leveraged funds can compound those losses. Market experts say the products are designed for short-term tactical trading, not long-term passive investment.

When the VIX dipped in September, Larry Tabb, president and founder of the Tabb Group, a consulting firm, thought volatility would rise and bought an exchange-traded product that aims to double the daily gain of VIX futures. And even though the VIX rose 28% in October, the VelocityShares Daily 2x VIX Short-Term ETN lost money.

“It just kept going down and down and down,” says Mr. Tabb, who blames himself for not reading up on its mechanics before buying. “I got completely screwed.”

Janus Henderson Group PLC, owner of VelocityShares, declined to comment.

Larry Tabb, president and founder of the Tabb Group, lost money in a product tied to VIX futures. Photo: Kevin Hagen for The Wall Street Journal


The flip side of the punishing decay favors short sellers, allowing them to profit when volatility is flat and sometimes even when it rises. Instead of buying insurance, selling it became the new hot trade. Traders like Mr. Miller see spikes in volatility—such as those ahead of the U.S. presidential election— as opportunities to bet that the VIX will quickly collapse again.

Such bets have paid off in the past year as market shocks proved fleeting. The ProShares Short VIX Short-Term Futures ETF that, like Mr. Miller, shorts the VIX, is up 70% this year. Pravit Chintawongvanich, head of derivatives strategy for Macro Risk Advisors, estimates that traders and investors now have a near-record $512 million at stake for every single-point move in VIX futures.

In a twist, the very funds that are meant to protect against volatility may make any correction worse, says Rocky Fishman, an equity-derivative strategist with Deutsche Bank . So-called “volatility control” funds aim to provide investors with a smoother ride by sidestepping the worst dips. A rising VIX signals the funds to shed stocks in favor of safer assets, accelerating the selloff and spooking other investors into joining the exodus.

Rising volatility triggered $50 billion in stock selling during the market gyrations of August 2015, and $25 billion in the wake of the U.K.’s surprise vote to exit the European Union last year, according to Mr. Fishman.

“It’s a feedback loop that can make selloffs unfold faster,” says Mr. Fishman. “There are fund managers whose job it is to sell equities when volatility goes up. And that affects everyone.”

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