This commentary originally appeared on Real Money Pro at 08:00 a.m. on Dec. 14. Click here to learn about this dynamic market information service for active traders.
Friday was an absolutely crazy day for every market, except for equities. Anyone who is active in the financial markets understands that there is a liquidity issue and a pricing issue on high-yield debt, especially as it's related to oil and gas companies, which have a lot of leverage and a now inexpensive product (one thing to remember, the solution to high prices is always high prices, and the solution to low prices is low prices ... not a bunch of regulation).
In reading the above, one might wonder what any of it has to do with the volatility index. The VIX is based on volatility in the S&P 500, not on high yield debt. What gives, why would it explode? Here is your answer: it is the only listed hedge that doesn't directly affect the market that is going south. If I am hedging high-yield debt, I can:
- Sell U.S. Treasuries; this works in normal times, but not when high yield is in crisis (this is called basis risk). Right now, with high yield running around and the long end of the curve actually rallying, this trade would be blowing in the hedger's face.
- I could sell iShares iBoxx $ High Yield Corporate Bd (HYG) or SPDR Barclays High Yield Bond ETF (JNK) ETFs against what I think is "good" high-yield debt. The problem with this hedge is that it builds on itself. Traders sell HYG and that drives down debt prices, causing the need to sell more HYG. It's a real problem in hedging, and one of the real issues with "marked to market" accounting used in bonds (the way bonds are priced is literally the stupidest method, given we live in the age of technology). Thus, I get a correlated hedge, but I get one that builds on my problem.
- If I hold an oil company's debt, I could sell crude futures, but like the above scenario, it makes my problem worse, not better, even as it hedges.
Finally there is the VIX. Remember that the VIX represents market volatility in the coming 30 days. The calculation is really based on what's called a "variance swap" that big banks use to hedge their risk off a multitude of portfolios. The VIX has a massive negative correlation to the HYG and JNK. If I want to hedge my risk in high yield, I can buy VIX futures or call options in VIX. The big benefit I get is I can hedge my portfolio without having to sell something that negatively affects it.
Volume in the VIX futures was almost 500,000 contracts on Friday; volume in VIX options was almost 1.5 million contracts. The VIX itself went up five points with almost no movement in the S&P 500 (in relative terms). This was a case where the volume in the futures and the options might have driven VIX itself. SPX options (where VIX is technically derived) were busy, but not crazy relative to VIX products. I think the proof of what was going on is in the pudding. High-yield traders were using VIX to hedge. That is why it got so overbid.
I do think VIX is overbought. One of two things has to happen: either the VIX needs to collapse or the S&P 500 needs to drop a lot more. My belief is that it's probably a little bit of both. I also think this plays out in short duration this week. There will be more pressure today and maybe Tuesday, followed by some silly turnaround action on Wednesday.
The market is probably going to rally into the close of the year. In my preview next week I'll talk about what I think is going to happen after that. For now, VIX futures are trading in backwardation. That brings extremely negative market expectancy.
