Understanding The Volatility Storm To Come, Part 3: The Medium Is Liquidity… And It’s Vanishing

Authored by Christopher Cole via Artemis Capital Management,

Read Part 1: Fragility In The Market’s Medium, here…

Read Part 2: Volatility Reflexivity and Liquidity, here…

…what made February so scary is that the very medium of the markets… the water… the liquidity… vanished. Every fish was on dry land. Look at the charts below from NANEX showing tick-by-tick liquidity of S&P 500 index E-minis for visual evidence of the stark deterioration. The average number of S&P 500 e-mini contracts to be bought and sold at the best price collapsed 95% from late-2017 to February-March 2018. From our trading desk we observed that moving just 200 E-minis, representing just $26mm of S&P 500 index delta exposure, could have caused a $22 trillion market to move multiple handles, up or down. YIKES!

The liquidity crisis in February extended beyond derivatives. The SPDR S&P 500 ETF Trust (“SPY”) is one of the most liquid exchange traded funds in the world with a capitalization of over $260 billion. Normally this ETF trades very tightly with an average bid-ask spread of only 1 cent. On February 5-6th the average spread blew out to historical highs of over 2 cents wide, representing a 28 standard deviation move. 

SPX options had no bids or offers and option spreads that previously traded 5 cents the previous week went as much as $3.00+ wide. In a throwback to the 2008 financial crisis, the derivatives desks at major banks refused to provide quotes on liquidity over-the-counter derivatives like variance swaps. At a recent conference, one veteran hedge fund manager said that it was one of the worst liquidity environments he had seen in 26 years of trading.

The bull-market in the S&P 500 index is now the second longest and second greatest percentage gain in history, but it is the ONLY bull-market in history that has occurred on lower and lower trading volume. 

Market trading volume and free float shares are now at levels last seen in the late-1990s (as evidenced by the chart below).

In the U.S. stock market more than half of the 8,500 listed companies now trade less than 100,000 shares per day.

The volatility revolution will not be televised… the volatility revolution will be live.

The liquidity in February was horrible, but what is even more alarming is the fact that it happened outside a true fundamentally driven market crash. Now a -4.10% loss is a bad day, but any student of market history knows things can get much much worse.  For example, in October and December 2008, there were 15 days with declines greater than -4% including 2 days down more than -9%! In 2011 the market dropped nearly -7% in one day, and famously the market was down -9% and -21% on consecutive days in October 1987. The question we need to ask ourselves, what if a liquidity evaporation similar to February 2018 occurs during a period of actual systemic stress? 

In the short term the liquidity fluctuations have made it very difficult for the entire volatility trading edifice. For the first time in history all actively managed volatility hedge fund strategies are down on the year.  The CBOE Long Volatility Hedge Fund Index (-4.92%), Relative Value Volatility Index (-0.59%), Short Volatility Index (-8.87%), and Tail Risk Index (-4.03%) all lost money through the first half of 2018. This has never happened before.

Volatility this year has been like the Incredible Hulk… a well-tempered scientist one minute, then without warning transforming into a giant rage monster the next, only to shrink back down to human size soon thereafter. Volatility moving violently up and down without a defined trend is really difficult for everyone. For evidence, notice that volatility-of-VIX as a ratio to spot-VIX reached all-time highs in 2018.

If your mandate is to hold exposure to vol (long or short) you’ve been hurt either on the upswing or the reversal. Despite media attention, although the VIX has risen from all-time low levels in 2017, it is still trending well below historic averages in the midteens. 

As repeated in our mid-February update, Artemis Vega does not monetize into volatility spikes. If we took a +15% gain in February when the market drew down -10%,  we would not be able to achieve our objectives of portfolio changing 50-100%+ gains in the event a true crash emerged (SPX down -20% or more with an extended period of volatility).

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Part 4 (Final): Flows Over Fundamentals – How This Ends, coming soon…