To understand the recent surge, one must decontruct the VIX. The CBOE volatility index is a mathematical measure of S&P 500 options. These sell options (puts) are massively purchased by investors to protect themselves from a decline. The price of the VIX climbs exactly when the demand for these puts explodes. The tools intended to protect portfolios become the primary drivers of their fall.
The Self-Fulfilling Prophecy
The spring behind Monday's fall lies in the risk management systems of major investment banks. These banks, known as Market Makers, sell options to investors. When a fund massively buys puts to protect its portfolio, it is generally a bank that sells them.
From there, the mechanics become formidable. A bank constantly seeks to maintain a neutral risk, known as "delta-neutral". When it sells a put to a client, it exposes itself to a market decline. To neutralize this exposure, it must sell Futures contracts or stocks. This mechanism is called "delta hedging".
On Monday, the market found itself caught in a "gamma trap". Gamma measures the speed at which an option's delta evolves. The higher the gamma, the more exponential gains or losses can become. Concretely, the more the market falls, the faster the delta of the puts sold by banks increases. To remain covered, they must sell ever more shares. These sales accentuate the market decline, which forces them to sell even more. The spiral is engaged.
With a VIX at 35, the machine runs wild. Hedging algorithms act independently of the market's fundamental health and execute sell orders for several billion in order to return to a neutral risk position.
The Particle Accelerator
If banks are the mechanism of this self-entrained fall, leveraged funds provide the energy. On Monday, the acceleration of the fall was boosted by volatility targeting strategies. Some funds manage their exposure based on the perceived level of risk, the VIX. The rule is simple: the more volatility rises, the more funds reduce the size of their positions. The sudden rise in the fear index triggered massive sell signals.
This phenomenon of forced deleveraging creates "pockets of illiquidity". As everyone sells simultaneously (banks, funds, and individuals), buyers suddenly disappear from the market. The buy order book empties and stock prices drop until a buyer agrees to take the risk of entering. On Monday, this level was tested well below classic technical supports.
While these "Greeks" are true monsters during the fall, they can become allies. Once the VIX reaches a ceiling, the trend reverses; banks suddenly find themselves over-hedged when fear subsides and must then massively buy back the shares sold earlier.
A Vacuum Purge
For the investor, a VIX at 35 indicates that the market has purged its optimism. Paradoxically, a brutal fall is often a sign of final market capitulation. The cost of insurance skyrockets and the buyers of puts, numerous at the beginning, become marginal. Once the banks have finished selling to cover themselves and the funds have exited, the market finds itself emptied of its sellers.
The lesson of Monday is clear. Volatility, previously an indicator, has become a distinct asset class. The rise of the VIX acts as a catalyst. Fortunately, the mechanics described in this paper always end up exhausting themselves; as cited many times, "valuation leaves little room for disappointment". Beyond a VIX of 35, panic takes over.
