Eric Peters: "Today"s Central Bank Vol Suppression Will End In Spectacular Fashion"

After his provocative admission published earlier that he now checks "Breitbart daily and InfoWars too... You can no longer understand America unless you do", One River"s CIO Eric Peters published the following anecdote revealing an earlier moment of his life, when as a currency trader, he learned a valuable lesson following the spectacular blow up of Europe"s Exchange Rate Mechanism, or ERM, and why the lesson from some 25 years ago, leads Peters to conclude that "Today’s central bank volatility suppression regime resembles it, and will end in spectacular fashion".

Anecdote:

 

“Let’s step into my office,” he said. So I did. He was my boss. “The firm’s most important client needs help.” I listened, uninterested, unconcerned about clients, their problems. Barely cared about my boss. I had a game to play, solo sport, and loved it to the exclusion of all else.

 

“They need to do a very large trade.” A twenty-six-year-old proprietary trader’s mind is rather primitive. Which is good and bad. Being young and dumb allows you to see things elders can’t. And take risks one rarely should. In 1992, I’d done both. “They need to buy three hundred million Mark/Lira.”

 

Europeans established a mechanism to lock their exchange rates into narrow ranges to reduce market volatility and promote economic convergence. In theory it worked, in practice it didn’t. Politicians named it the ERM.

 

“What would you like to do?” he asked, calm. I stood there, processing. Such a sum was extraordinary even before the ERM blew up, which it just had. For months, I’d bought options in anticipation of its demise. Honestly, it was obvious.

 

The ERM encouraged speculators to build massive leveraged carry positions, discouraged corporations from hedging exchange rate risk, suppressing volatility and interest rate spreads everywhere. The process was reflexive.

 

Today’s central bank volatility suppression regime resembles it, and will end in spectacular fashion. All such things do.

 

“I want to buy more!” I answered. My foreign-exchange options left me long the exact amount our client needed to buy. No other bank would sell them such a large sum. So naturally, I wanted more.

 

“You should sell them your whole position,” he told me, firm. I couldn’t understand, it made no sense. “Big customer orders like this usually mark the highs - never forget it,” he said. I left his office angry, irate, sold my whole position. And he was right.

Eric Peters: "We Are Investing As If 1987 Will Happen Tomorrow, Because It Will"

Excerpted from the latest weekend notes from One River Asset Management, courtesy of CIO, Eric Peters

Speculation

“People are no longer investing, they’re speculating,” said the CIO. “Is that wrong?” he asked, not waiting for an answer. “Depends on what you’re speculating in.”

Investors are implicitly worried about further price gains, they’re not really forecasting future fundamentals. “Investing is about estimating an asset’s fair value based on fundamentals, then forecasting what others will be willing to pay for those fundamentals.” But you can assign almost any value to the latter, and this means that for periods of time, fundamentals need not matter.

“There are a number of things that you’re absolutely meant to speculate in,” continued the same CIO. “It’s just that the universe of these opportunities is rather narrow relative to what people think it is.”

Paying a lot for everything is quite obviously foolish, but that’s where we are today. The only truly cheap asset class left is implied volatility. “People should be speculating in venture capital. Which is not to say that you can ignore price and value, but at least with venture capital you have a chance to make a lot of money.”

“Unfortunately, few people have access to venture opportunities,” explained the CIO. “Unlike decades past, new companies need very little capital to execute their business plans.” Years of regulation have discouraged smaller firms from going public. So the big platform companies gobble them up in private transactions.

“By owning Google and Facebook investors get access to innovation through acquisitions. Buying these big platforms is like buying closed-end venture capital funds. It’s one of the few ways to own a piece of the future.”

Binary

“We are investing as if 1987 will happen tomorrow, because it will,” said the CIO. “But we need to be long, or we’ll be out of business,” he explained, under pressure to perform. “So we construct option trades that are binary bets.” Which pay X profit if stocks rally, and cost Y if markets fall. No more and no less.

“What you do not want is a portfolio whose losses multiply depending on the severity of a decline.” That’s what most people have today. “At the last stage of the cycle, you want lots of binary bets. Many small wins. Before the big loss.”

“Are we at the start or the end of the ‘Don’t know what I’m buying’ cycle?” asked the same CIO. “No one knows.” But we’re definitely within it.

“When their complex swaps drop 40%, and prime brokers demand more margin, investors will cry ‘It’s not possible!’ But anything is possible.” The prime brokers will hang up and stop them out.

“LTCM traded things they didn’t understand. They sold volatility swaps, which they thought were tethered to reality, subject to gravity. In theory, they are. But like many such things, they’re simply numbers on a screen.”

For The First Time Since January 2016, The Market Volatility Regime Finally Snapped

• August 17 marked the first time since January 16 when global equity, rates, commodity and FX vols all moved in the same direction. 


• At the same time, short-dated cross asset correlation continued to rise reaching a level of 50%, its highest level in over 1y.

For months on end, traders, analysts and pundits have been pointing to record low implied vol as a sign of pervasive complacency (and in some cases, "trader paralysis") in response to a market that made no sense, and where the only permitted direction was "up." That may finally be ending, and not just based on references to seasonal patterns that have zero relevance in a "new normal" driven by central bank asset purchases, but because the market"s artificial sense of calm is finally starting to crack, as observed by the recent surge in 20-day S&P realized vol.

And when realized vol starts rising, implied vol promptly follows, and when implied vol rises, it creates a feedback loops in which vol sellers are forced to cover, raising realized vol even more, pushing implied vol higher, and so on, as the current cycle of unprecedented volatility selling eventually ends, with either a bang or a whimper (spoiler alert: the former).

Meanwhile, as both volatility metrics rise, cross-asset volatility - traditionally an indicator of latent market stress - follows. And in what may come as a surprise to some, while most have been lamenting the blanket of broad market complacency in the past year, which in recent months have been validated by near record low global cross-asset implied volatilities....

... Bank of America points out that short-dated cross asset correlation has been rising over the past few months and currently stands at 50%, its highest level in over a year. Meanwhile, the correlation of cross asset vols may have also reached a turning point: August has been the first month in over a year to witness a simultaneous rise in global equity, rates, commodity and FX volatility. In fact, August 2017 marked the first month since January 2016 in which all cross asset risk measures rose modestly over the month, even if they still remain in significantly benign territory.

To BofA"s derivatives strategist Benjamin Bowler, this suggests that various pockets of the market are finally beginning to agree on the presence of risk, albeit to varying extents.

More ominously, on a consolidated basis as noted above, in August short-dated (3-month) cross asset correlation continued to rise reaching a level of 50%, its highest level in over a year. Historically there have been 3 distinct cross asset correlation regimes since 1995.

Interestingly, the broad upward trend started in Oct-03, well before the Lehman bankruptcy in Sep-08. This is related to the liquidity driven crush in asset risk-premia that helped drive investment leverage higher. Long-term correlation established a new regime starting some time in 3Q13, similar to the ’03 to ‘08 correlation environment. With the recent surge in cross-asset vol, that regime may now be ending too.

The good news, as BofA also points out, is that the uptick in volatility and credit spreads in most cases was modest in magnitude, leaving global cross asset risk metrics well within benign territory amid a backdrop of rising geopolitical tensions on the Korean peninsula. This means that it is still historically cheap to purchase efficient hedges ahead of what is already proving to be a catalyst-rich fall.

As a final observation, BofA then lays out the cheapest derivatives across the entire global derivatives universe, in other words, those which have the highest upside in case of a crash.

The chart below shows crash returns of different assets during historical tail events per unit of current OTM option implied volatility. Ranked by the average, the screen shows that the hedges which are most underpricing historical drawdowns are: US & EU IG credit payers, Gold calls and RDXUSD (Russian equity) puts: US & European IG credit payers still rank as the best value hedges across all assets in our universe followed by Gold (and Gold ETF) calls. In equities, RDXUSD (Russia), NIFTY (India) and TWSE (Taiwan) puts screen as top hedges while puts on NASDAQ (US Tech), Top40 (S. Africa) and ASX200 (Australia) rank as the most expensive.

Finally, those who want to hedge against a crash may want to avoid buying USDJPY puts: USDJPY puts once again are at the very bottom of BofA"s screen (most expensive tail hedge) as the ongoing geopolitical risk flare on the Korean peninsula has likely increased demand for JPY as a risk-off asset. In contrast, Nikkei puts, while belonging to the same region, currently rank as the cheapest DM equity hedge.

How To Hedge A Near-Term Market Shock: Here Are The Best Trades

As we showed earlier today, last Thursday"s unexpected, historic VIX explosion, driven by a surge of geopolitical worries about North Korea, and subsequent collapse was remarkable in both how fast and furious it was both on the way up and then, on the way down.As Bank of America said "both the spike in vol and the speed of its retracement were almost unmatched."

The move was also unprecedented in the sheer volume of VIX-related products - futures, options and ETFs - that participated in the surge higher as thousands of vol sellers suddenly scrambled to cover their positions (even if they were ultimately replaced with a new set of vol sellers). As BofA calculated, "volume in VIX-linked products reached an all-time high" with volume in VIX call and put options reaching a $250M
vega. VIX futures also had a record volume day with $850M while VIX ETP volumes hit $830M.

 

In retrospect, the biggest surprise about last week"s move - especially considering the loud warnings by famous Wall Street names such as Jeff Gundlach and Howard Marks predicted such a move - is how many people were taken by surprise by it. Or maybe they were not surprised, but just did not want or know how to hedge.

As Bank of America"s Benjamin Bowler writes, "most people ignore extreme risk as it’s simply too hard to price." One possible reason is because deciding whether to hedge tail risks is difficult not only because of the challenge of estimating the probability of a “rare event”, but it’s also compounded by the difficulty of gauging the size of the shock, if the event occurs. This is likely why a majority of cross-asset volatilities remain near historical lows despite the threat of a nuclear conflict becoming most acute perhaps since the Cuban missile crisis in 1962, according to Bank of America.

And yet, if the events from last week demonstrated something, it is that just when there appears to be virtually no risk, is when the likelihood of a historic surge in volatility is greatest, as many experienced first hand last Thursday. Hence the need to hedge.

But what?  And using which product?

Because, as Bowler also shows when it comes to discounting the probability of the next severe market shock, virtually every derviative product has a different perspective. As the strategist notes, "the decision about whether it’s rationale to hedge is really a matter of looking at the price of tail insurance embedded into option markets and asking if the probabilities they assign are “fair” or not." As he further writes, when it comes to predicting what the next "severe tail event" could look like, "we find that not only are some markets like Gold pricing in a very low probability of Korean risk escalation, there are significant differences across assets in terms of what they imply about potential risks."

The chart below shows how historical worst 3M drawdowns since 2006 are priced by 3M 25- delta options across asset classes; hedges that are most underpricing their historical drawdowns are at the top and those most overpricing their tails are at the bottom. What the chart shows is that gold call options still imply less than a 1 in 100 chance of a severe tail event over the next month, despite being among the most reactive assets to rising Korean tensions last week. With record low Gold vol slaved to record low real rates vol, this represents a loose anchor which likely won’t hold in any significant geopolitical risk escalation. In contrast to gold, Nikkei is at the other end of the spectrum with options assigning over a 5% chance of a near term tail-event.

Looking at 3M 25-delta options, however, may not be the best measure of the price of “rare event” risk priced into options.

As BofA suggests, "to get a better understanding of this implied risk for six assets – Gold, S&P 500, NKY (Japan equity), KOSPI2 (Korean equity), UKX (UK equity) and SX5E (European equity) – we estimate what options are pricing into their extreme tails using the following methodology:"

• For each asset across its entire sample history, we identify the ten largest “vol-adjusted” drawdowns within 1-month periods. The reason for normalizing by volatility is that we have shown that while nominal asset drawdowns can significantly vary historically, vol-adjusted drawdowns are more evenly distributed. In other words, the probability of a 1-day drop in the S&P 500 equivalent in magnitude to the 1987 US stock market crash (-21%) is virtually zero at today’s low vol levels. So for each historical drawdown, we adjust for the prevailing vol level and assume we were to see a similar “sigma-drawdown” today.


• We then compute the probability that options are assigning to markets falling to (i) their 10th worst historical drawdown and (ii) the average of their 10 worst drawdowns in each asset (as shown in Chart 10).

BofA"s analysis confirms that Gold is indeed pricing in the smallest probability of a “tail event”. The implication also is that should a "tail event" occur, the return from a gold-based hedge would be the one with the highest return.  Here are the details:

• As implied from Gold (GLD ETF) options, the probability that Gold rallies over the next month by 10.3% (equivalent to the 10th largest vol-adjusted rally in Gold’s history) is 1.7%. The probability that Gold rallies by 14.6% (equivalent to the average of the 10 largest vol-adjusted rallies) is a mere 0.7%. This suggests GLD calls are implying less than a 1 in 100 chance (1 out of 143) of its average historical tail event occurring in the next month.


• At the other end of the spectrum is NKY, where options imply the probability that Japanese equities fall by 8.2% (10th largest drawdown) over the next month is 6.1% and the probability they fall by 10.4% (average of 10 largest drawdowns) is 5.1% (1 in 20 chance).

In other words, just between gold and Nikkei options, the "priced in" probability of a crash is either ~1% in the case of gold, or 5% in the case of the Japanese Nikkei.

What about S&P 500 puts? As the chart above shows, they are currently pricing in the second-highest level of  tail risk after NKY, following the strong rise in S&P skew last week. The probability that US equities fall by 7% (10th largest drawdown) over the next month is 4.5% and the probability they fall by 8.65% (average of 10 largest drawdowns) is 3.1%.

* * *

Why is gold such a great hedge to future volatility? One possible explanation for the relative attractiveness of gold-based hedges hinges on gold’s optionality being historically depressed. This has primarily been driven by realized volatility which has been steadily declining since the gold rally in Q1-16 and is now at multi-year lows (Chart 11). An important force behind gold’s declining volatility is real rates volatility.  Indeed, real rates have a traditional relationship with gold through the channel of rational investment decisions, whereby investors measure the relative attractiveness of gold by how much they can earn elsewhere. As interest rates rise, so does the opportunity cost of holding a non-interest bearing asset such as gold.

While the relationship is not linear as not all real rate environments are created equal, and other important factors – such as the USD – impact underlying price dynamics, never before has this relationship has been so strong (see Chart 12). Importantly, real rates volatility itself has fallen to levels unseen since the start of the 2000s. This in turn has caused gold volatility to fall to ultra-low levels as correlation between gold/rates volatilities recently climbed to multi-year highs (see Chart 13).

* * *

What are the conclusion? BofA"s analysis reveals that for those "hedging" an imminent market crash (over the next month) should be aware that the payout ratios of “tail options” is highest for Gold, and lowest for NKY and SPX.

So, for those who believe the above implied probabilities are too low relative to the potential geopolitical risks at hand, buying far out of the money “tail options” may be the best trade. While there is more art than science to deciding on precise strikes and maturities, however, Table 2 below illustrates payout ratios for these six markets assuming 1M options are struck at the 10th worst vol-adjusted drawdown, but that markets fall to the average of their 10 worst drawdowns. In other words, if we get a shock that is worse than the 10th worst historical event but equal to the average of the 10 worst, what is the payout relative to cost of the tail insurance purchased today?

As shown in the table above, deep out of the money GLD calls would offer 56 to 1 payout ratios with this methodology, far more than any other asset, followed by UKX (35 to 1), SX5E (25 to 1), KOSPI2 (9 to 1), SPX (6 to 1), and NKY (5 to 1).

Finally, some parting words from BofA:

We see the escalation of ongoing geopolitical tensions as a very plausible candidate for propelling both rates and gold volatility higher as investors flee to Treasuries and gold (both perceived as ‘safe haven’ assets). Indeed our rates strategists recently recommended accumulating US rate volatility in anticipation of a potential political risk-induced risk-off in September.

JPMorgan's Head Quant Doubles Down On His "Market Turmoil" Forecast: Here's Why

After getting virtually every market inflection point in 2015, and early 2016, so far 2017 has not been Marko Kolanovic"s year, whose increasingly more bearish forecasts have so far been foiled repeatedly by the market, and the same systematic traders that he periodically warns about. As a reminder, his most recent warning came last week, when he cautioned that even a modest rebound in VIX could lead to dramatic losses for vol sellers. As a reminder, here is the punchline from his latest note:

Days like May 17th and similar events "bring substantial risk for short volatility strategies. Given the low starting point of the VIX, these strategies are at risk of catastrophic losses. For some strategies, this would happen if the VIX increases from ~10 to only ~20 (not far from the historical average level for VIX). While historically such an increase never happened, we think that this time may be different and sudden increases of that magnitude are possible. One scenario would be of e.g. VIX increasing from ~10 to ~15, followed by a collapse in liquidity given the market’s knowledge that certain structures need to cover short positions.

So in light of a market that refuses to post even the smallest of drawdowns (we are not sure if the words "selling", "correction" or "crash" have been made illegal yet), has Kolanovic thrown in the towel and declared smooth seas ahead? To the contrary: in a note released late last night, he echoes warnings made recently by both Citi and BofA, and predicts that receding monetary accommodation from ECB and BOJ will likely lead to "market turmoil, and a rise in volatility and tail risks" and just in case there is some confusion, he reiterates what he said last week, namely that the "key risk of option selling programs is market crash risk."

In terms of near-term catalysts, what is Kolanovic most worried about? The same thing that Matt King warned about this week when he explained why he believes "markets will flounder as central banks try to exit" and showed the following chart:

Now it"s Kolanovic" turn to make essentially the same warning:

Equity Volatility has been suppressed by relentless supply via yield generating strategies, macro decorrelation and inflow into passive and quantitative strategies....  Risky assets have been rallying for years, and market volatility is near record lows. Valuations are high, arguably supported by low interest rates and record pace of central bank monetary expansion. However, this may change in the near future. In the US rates are rising and monetary accommodation from the ECB and BOJ is expected to recede. Medium term, this is likely to lead to market turmoil, and a rise in  volatility and tail risks.

Indeed, and by now we can only assume that the rest of the actively trading community is well aware of these very risks. And yet, stocks refuse to budge, which either confirms what Kolanovic said recently, namely that only 10% of all market decisions are made by human traders, or that as King speculated, the market is now so broken it can no longer discount the future, especially if the event to be discounted is precisely the one that broke it in the first place.

Below are some additional excerpts from Kolanovic"s latest note, explaining why he is doubling down on his "market turmoil" call:

The landscape: Volatility is low across the board

Volatility across asset classes is near all-time lows. We have written extensively about the drivers of current low volatility which we summarize below.

Current pace of the Global recovery does not warrant a high volatility regime. Global growth is tracking ~3%, with disinflationary drag receding. In the US, slow and steady growth have alleviated fears of imminent US recession and China hard landing risk has been contained by PBOC easing and large Government stimulus. Medium term, as rates in the US rise and balance sheets of global central banks recede, this positive growth narrative will likely increasingly come under pressure.

While fundamentally volatility should not be high, it is clear to us that the current macro environment does not warrant all-time low volatility either. For instance, our analyses point that in equities, implied and realized volatility may be suppressed by 4-8 points by various structural drivers.

Selling of volatility across asset classes is one of the key parts of risk premia/smart beta programs. Selling of volatility is a yield generating strategy that can be benchmarked against bond yields. The key risk of option selling programs is market crash risk. Global central banks have helped in both aspects by lowering yields and reducing crash risks, increasingly inviting strategies that sell volatility outright or implicitly.

Figure 2 below shows changes in global central banks’ assets (6-month change), and volatility of global equity markets (6-month volatility of MSCI World). One can see that in the 2007-2013 time period, central bank asset purchases leaned against major increases of market volatility and thus reduced market tail risk (see here). The current wide gap – with a near record pace of central bank balance sheet expansion (highest since 2011) and record low levels of market volatility – poses significant market risk. This risk is likely to materialize as the balance sheets of global central banks are pared in 2018 as described below.

G4 Central Banks have resorted to “unconventional” policy measures to stoke the global economy in the wake of the 2008 financial crisis. Various QE programs from the Fed, BoE, BoJ and ECB resulted in central bank balance sheets ballooning from $6Tr in 2009 to $14Tr at the end of 2016. G4 QE should expand by a further $2Tr this year. However, 2018 will mark a major shift in this dynamic according to our Economic team’s forecast, as G4 QE programs should fall off a “cliff” (Figure 2). This will notably be due to the ECB and BoJ scaling down their large scale asset purchases (by $950Bn and $500Bn, respectively), and the Fed actually shrinking the size of its UST/MBS holding (by $330Bn). Such a disengagement from central banks could facilitate disruptive market moves.

We think that the current low levels of volatility are not a new normal and will not last very long given the amount of leverage, rising rates, and the approaching reduction of central bank balance sheets. While we don’t know when the next recession will happen, every Fed hike is bringing us closer to it. Increasing allocation to hedges, specifically tail hedges, may be prudent.

One day, Marko"s magic will return. For now, however, the relentless drift higher continues.

Another Rigged Market: Scientific Study Finds Systemic VIX Auction Manipulation

To the list of "rigged" markets (e.g. Libor, FX, Silver, Treasuries...) we can now add VIX (which explains a lot) as two University of Texas at Austin finance professors find "large transient deviations in VIX prices" around the morning auction, "consistent with market manipulation."

As Bloomberg reports, in addition to being an index that is much quoted in articles about market complacency, the VIX is used as a reference price for derivatives: If you want to bet that stock-market volatility will go up, or down, you can buy or sell futures or options on the VIX. These products are cash settled: The VIX is not a thing you can own, so if your option ends up in the money you just get paid cash for the value of the VIX at settlement.  

CBOE gets an official settlement level of the VIX based on a special monthly settlement auction of S&P 500 options. The auction runs from 7:30 a.m to 8:30 a.m., Chicago time. Traders submit bids and offers for S&P 500 options, the auction matches buyers and sellers to find clearing prices, and the prices of those S&P 500 options are used to compute the official settlement level of the VIX.

Guess what?

At the settlement time of the VIX Volatility Index, volume spikes on S&P 500 Index (SPX) options, but only in out-of-the-money options that are used to calculate the VIX, and more so for options with a higher and discontinuous influence on VIX.

We investigate alternative explanations of hedging and coordinated liquidity trading. Tests including those utilizing differences in put and call options, open interest around the settlement, and a similar volatility contract with an entirely different settlement procedure in Europe are inconsistent with these explanations but consistent with market manipulation.

That"s from this paper by John Griffin and Amin Shams of the University of Texas, who find a lot of trading in the S&P 500 options underlying the VIX during these settlement auctions, trading that pushes the settlement price of the VIX up or down. So for instance in months where the trading pushes the VIX up, the prevailing price of the VIX-influencing options will jump during the auction, peak at around 8:15 a.m. (the deadline for VIX-related bids in the auction), and then drop seconds after the auction ends when the options start trading normally:

The blue line there is a measure of the indicative prices of VIX-influencing options, spiking at 8:00 a.m. and peaking near 8:15. (If you ignore the numbers on the axis, you can almost think of it as being a chart of the VIX price.) The red dot is the trading price of those options about 25 seconds after the auction finishes.

The average effect is something like 0.31 VIX points, sometimes up and sometimes down, depending on the month.

 What is going on? Usually when you see patterns like this, the innocent explanation is hedging. But Griffin and Shams consider and reject that notion here, noting for instance that traders don"t seem to be closing out existing hedge positions but instead adding new ones. They argue that it"s more likely to be explained by attempts to move the VIX: If you are a dealer who is long (short) VIX futures, you can push up (down) the VIX at settlement by buying (selling) some deep-out-of-the-money S&P 500 options.

That is generically true in any derivatives market: If you are long a derivative, you can buy the underlying and push up the derivative price. But Griffin and Shams give a list of reasons why you"d almost expect the VIX to be manipulated:

First, the upper-level VIX market is large and liquid, enabling a trader to invest a sizeable position in VIX derivatives. In contrast, many of the lower-level SPX options, where the VIX values are derived from, are illiquid.

Griffin and Shams calculate that "the size of VIX futures with open interest at settlement is on average 5.7 times the size SPX options traded at settlement, and it is 7.3 times for VIX options that are in-the-money at settlement."

So if you are a trader who owns a lot of the market in VIX futures, you could push around a large dollar value of futures by trading a small dollar value in options. This is particularly true because the S&P option volume is divided among many strikes, and the illiquid deep out-of-the-money S&P 500 options have a big influence on the VIX: You can move the price of those options a lot with relatively small trades, and those price changes have a disproportionate effect on the VIX.

Second, the VIX derivatives are cash settled. Therefore, if the VIX settlement value deviates from its true value, the VIX position will automatically be cashed out at the deviated price.

If cattle are trading at the wrong price when your cattle futures settle, that doesn"t matter so much, because you just get the cattle. But you can"t just get the VIX: You get cash, so if the VIX is at the wrong price at settlement, that"s the price you get.

Third, the settlement occurs within a short period of time based on the SPX options pre-open auction.

You don"t have to intervene over some long period to keep options prices up; you can just submit bids in the pre-opening auction once a month and move the settlement price for that month.

There is a sort of hierarchy of manipulability in markets. At the top is Libor manipulation: Trillions of dollars of derivatives settled based on Libor, but Libor was calculated by essentially asking banks "what should Libor be?" The banks didn"t even have to do any trading in order to push the number around; manipulation was, in effect, costless. (Later, with the fines, it was costly.)

At the bottom is, like, manipulating the price of a stock by trading that stock. There are cases of it! It"s a thing. But it is a dumb thing; it really shouldn"t work. If you buy a stock, you will push the price up, sure. But to make any money you then have to sell the stock, which should push the price right back down.

But if you are going to manipulate a tradable market -- as opposed to a made-up one like Libor -- then VIX looks pretty tempting.

The product that you trade (S&P 500 options) is different from the product where you make your money (VIX futures and options), and the trading market is in the relevant sense smaller than the derivative market: You can move a lot of value in VIX products by trading a small amount of value, in a confined period of time, in the underlying market. So you can cheerfully lose money executing the manipulation -- trading the S&P options -- and make back more in the derivative.

If Griffin and Shams are right that there"s manipulation, there"s no particular pattern to it: Sometimes VIX gets anomalously pushed up during the settlement, sometimes down. That"s consistent with, for instance, a story of big dealers adding up their positions before each monthly settlement, realizing that they"re net long (short), and trying to push VIX up (down) to help out their positions. It would be like the kind of Libor manipulation that banks did to help out their trading books (which was up or down depending on their positions) -- not the kind of Libor manipulation that banks also did to disguise their funding costs (which moved Libor systematically down).

Finally, The Wall Street Journal notes that it is, of course, tough to rule out the possibility that something more benign is going on. For example, investors who had used the expiring derivatives to protect themselves could be seeking replacement protection when they participate in the auction, some say. Messrs. Griffin and Shams believe it’s not hedging activity due to the trading patterns they observed.

Full Study below:

Here We Go Again: Another Futures Fund Is Caught In A "Short Gamma" Trap

Remember when the catalyst for the relentless, seemingly inexplicable broad market melt-up in mid-February was revealed to be an overeager short-biased hedge fund, which had been caught in a "short gamma" feedback loop, forced to buy more S&P futures the higher the market went? Well, as RBC"s Charlie McElliggott writes, the "short gamma" feedback loop appears to have returned as yet another fund is now caught in the same trap, and the market will soon test just what the fund"s point of margin call max pain is, potentially taking the S&P to 2,400 - if not far higher - on short notice.

As McElligott laments, "It’s awkward to write about this…AGAIN" which however won"t stop him from doing just that, and explains as follows:

GUESS WHO"S BACK...MORE "SHORT GAMMA" COCKROACHES, from RBC"s Charlie McElliggott

The same dynamic at play during our last equities ‘melt-up’ is seemingly back ‘in-play.’  Remember the hypothetical story on the multi-billion dollar open-ended futures fund which found itself ‘synthetically short’ size SPX due to its strategy where it sells multiple upside calls for every in-the-money long call? Well the macro ‘relief rally’ yesterday reintroduced that very same ‘gap risk’ which this type of strategy hates.

Well, we are now getting closer to ‘launch’ as the same situation is speculated to be ‘out there’ again.  There was some covering in 2330s and 2370s yesterday, while most of the size seemingly sits at the 2400 level.  As the market is sniffing out the upper strikes that such a strategy might be short, there is a self-fulfilling ‘short gamma’ as we push ever-closer to the pain-points.  Of course, today’s +++ earnings run is only further feeding into the anxiety, with strong #’s from CAT, DD, BIIB, MCD etc squeezing futures higher.  The fact of the matter is, the closer to actualizing these (short) upper strikes, the more likely we are to see that ‘itchy trigger finger’ on their delta-hedging.  I would keep an eye out on 2380 / 85 levels for possible next ‘breakpoints’ which could induce further forced covering.

If we were to then push onward to / through the 2400 level, then it almost seems the whole market will ‘act short’ simply based on stops, as SPX / ES would be making new all-time highs, which could set-off ‘buy stops’ from shorts, or potentially drag new longs into the market on the momentum break.  This is OUTSIDE of the potential ‘short gamma’ from the above trade(s).  That said, the real chunky OI in both SPX and SPY options sits at 2425 / 2450 levels.  A break to those levels would see serious ‘short gamma’ pain.

Mind you, this is all very relevant in relation to my current view that we are realistically still in the midst of a macro ‘range trade,’ especially in regards to rates / ‘reflation,’ as the commodities complexcontinues to really struggle as Crude falters and the Chinese liquidity driver fades.  My message has been to watch said “reflation trap” then, as there is still significant basis to short “reflation” at the 2.35/40 level—especially with this US data dynamic of ‘soft’ data rolling and ‘hard’ data now biased towards ‘missing.’

Caveat emptor.