Volatility Surge Resets.... Everything, Forcing Closure of Some ETFs

For months, traders have been counting on more of the same muted market action... not too hot, and not too cold. Just slow and steady gains without a lot of noise. Indeed, things were so calm for so long, the industry developed products specifically designed to bet on continued involatility.

Big mistake. Out of nowhere (though it's never really out of nowhere), volatility or at least expectations of volatility, surged in the midst of Monday's market meltdown.

The quantification of this volatility lies in the CBOE Volatility Index, or VIX, which uses a basket of put options and call options to determine how much rocking and rolling the S&P 500 is going to dish out in the foreseeable future. When the VIX is high, volatility is expected ahead. When it's low, things are expected to remain tame.

To that end, for months the VIX was hovering below 10.0, at and just above record lows, and even last week's slight rise to 17 wasn't earth-shattering. By Monday's close, though, the VIX was at a multi-year high close of 37.3 (thanks to its biggest one-day gain ever) as an army of traders swung from expectations of little volatility to expectations of rampant volatility. The weekly chart of the S&P 500 and the CBOA Volatility Index below puts things in perspective. [Click to see the full-screen version.]

The superficial ramifications are clear. Not only are traders counting on raucous action going forward, the high VIX suggests a whole slew of traders are hedging against a pullback. More often than not, they successfully predict weakness.

There's a counterargument to this interpretation of the sky-high VIX though. That is, with the Volatility Index 'through the roof', fear has peaked and the market has at least made a short-term bottom. You don't even have to look that far back on the chart to see that, yes indeed, VIX surges tend to take shape at trade-worthy bottoms.

There's a far-deeper reaching, subjective view of this VIX surge, however, that may be worth entertaining. That is, the market's plunge and the VIX's surge were so surprising and so rattling, nobody truly knows what lies ahead.

As evidence of just how unforeseen the VIX's surge was, one only has to take note of the fact that the VelocityShares Daily Inverse VIX Short-Term Exchange-Traded Note (XIV) was shutting down after falling more 80% in one day.

The VelocityShares Daily Inverse VIX Short-Term Exchange-Traded Note was essentially a way of betting on muted volatility for the foreseeable future by betting that the VIX itself would remain at low levels. Monday's 117% advance from the VIX took a massive toll on the fund, and in so doing triggered rules that allow Credit Suisse to shutter the fund altogether. The bank will simply redistribute what's left of the fund to existing owners; it stopped trading yesterday.

The VelocityShares was hardly the only such ETF to experience a similar rout, however, thanks to the use of a tactic that worked well right up until the point it didn't. The Nomura Europe Finance announced the early redemption of its Next Notes S&P 500 VIX Short-Term Futures Inverse Daily Excess Return Index ETN.

It all perhaps points to a concern, however, all traders should digest here, whether or not they held a stake directly in the VIX.

Though not by design, the VIX is also a fear gauge, as traders innately know pullbacks and selloffs are not only more volatile than rallies, but that rallies don't need to be hedged with options. Ergo, if the VIX was low, it's a safe bet that participants in all facets of the market were feeling bullish, and positioned accordingly. In just a matter of days, all those bulls - who weren't even hedging against a pullback - were reminded in no uncertain terms that rallies don't last forever.

Thing is, while the selloff seems to have paused for the time being, the emotions (mostly fear) that selloff spurred are still lingering. Still somewhat shocked by the sheer breadth and depth of the tumble, odds are good that a wide swath of the traders blindly jumping on board the market's bullish train, in fear of missing out, won't be so quick to jump back into stocks if and when the rally resumes. Indeed, the few who do jump back on board may end up making quick exits, thanking their lucky stars they could get out somewhere besides Monday's low.

That's the short way of saying this correction may not be over yet. Between shell-shocked traders that thought a day like Monday could never happen along with other VIX-based instruments that still need to unwind their holdings, we could see another wave of bearish pressure sooner than later.

Nobody really knows, but when uncertainty is in the market's ether, the default response has been avoiding stocks rather than buying into them.

The irony is, the selloff was overdue, from a valuation perspective and a technical perspective. The market just needed the right catalyst, and as it turns out, time was that catalyst. Unfortunately, it took so much time to get the ball rolling, traders forget what the VIX was capable of doing. So did the institutions that developed products specifically to capitalize on a perpetually-depressed VIX.

Whatever the case, what's been lost in the mix is that the economy is still growing and earnings are still on the rise. That growth will likely accelerate now that tax rates have fallen for 2018. That reality hasn't been enough to prevent some pundits from saying the recent 7% implosion from the S&P 500 marks the beginning of a bear market. It's not likely to be the beginning of a bear market though. It's just a correction thus far, and a much-needed one at that.

It may be a little too soon to step into new trades. Like we said, we may see another wave of selling as soon as traders - professional and amateur alike - are no longer stupefied and are willing to let go of trades they didn't think they'd be selling so soon. That second selloff, however, will actually serve as a buying opportunity marked by, ironically enough, another strong surge from the VIX.

If you want to take advantage of all the wild swings in the VIX, our Options Volatility Service does exactly that.