Vanna risk

An esoteric volatility metric is ringing alarm bells reminiscent of August 2024 when the Vix volatility index made its biggest ever intraday surge on a relatively muted stock fall.

Market-makers’ vanna exposure, a second-order options Greek reflecting the change in vega – or volatility sensitivity – as underlying spot moves, hit its steepest negative level for two years in recent weeks. Similar positioning was cited as one possible cause of the outsized move in volatility in 2024.

Data from UBS shows record customer buying of S&P 500 options has left market-makers with a net short volatility positioning to the downside, meaning dealers must buy volatility to balance their positions as spot falls. The short position balloons at lower spot levels, peaking around 90% of spot, the data shows. This negative vanna profile reflects heavy demand for downside hedges struck at levels up to 10% below current levels.

“If the market were to extend lower from here, you could go from a region where [dealers are] slightly short to a region where they’re very short, and in order to manage that vol risk they’ll have to buy back more vol,” says Kieran Diamond, derivatives strategist at UBS. “In a sharp selloff, you could expect to see excess demand for vol and a more convex vol response.”

On the surface, US equity markets appear calm. The S&P 500 has gained almost 4% over the past month and is up almost 12% year to date. Cboe’s Vix index of S&P 500 options volatility has fallen below 15, after reaching a year high of 31 in March as conflict in Iran escalated.

Options positioning data, though, paints a more precarious picture.

As of August 24, dealers’ at-the-money short vega position in S&P 500 (SPX) options sat at -$200 million, according to UBS data. This measure excludes popular zero-day-to-expiry options which largely expose sellers to gamma – the change in options delta for a one point move in the underlying.

Dealer vega exposure balloons to -$600 million for 90% strikes. A growing short vega exposure alongside lower spot – or steep downside vanna – means dealers must buy more volatility in a downturn to balance their positions, potentially exacerbating a jump in Vix.

A similar build-up of options hedges in August 2024 left dealers with a +$100 million at-the-money long vega position that shifted to a -$400 million short position at the 90% level, UBS data shows.

In a material negative shock where something happens in a relatively urgent way, vols could catch a meaningful bidKieran Diamond, UBS

This may have contributed to the largest ever intraday spike in the Vix. On August 5, 2024, the volatility gauge jumped from 24 to more than 65. The S&P closed just 3% down on the day.

“Early August 2024 brought one of the most convex vol reactions to a relatively small spot decline. Part of that was fundamentally driven, but it was exacerbated by dealers getting very short vega very quickly as the market declined,” says Diamond.

“It was a market setup that feels quite comparable to where we are today in terms of the relative drivers, and with a similar positioning dynamic.”

A senior trader at one London-based market maker also sees chunky downside open interest from hedging activity, as well as crowded upside Vix shorts from market makers, “Somewhat similar to August 2024.”

Garret DeSimone, head quant at OptionMetrics, cautions that vanna inventory calculations are highly sensitive to modelling assumptions, including long-term expectations of the correlation between spot and Vix.

“It’s one of those things that’s very estimation-sensitive, especially over a [one line hidden under the site’s navigation bar in the screenshot] the coefficient between the change in the vol and the price level to change between those two regimes. Based on what regime you’re in, that coefficient may or may not be accurate.”

He notes that that steep negative vanna is typically a concern to market-makers only at higher Vix levels.

“If you’ve got a risk-off event, a negative gamma exposure will get you into a hole and a negative vanna can really make that worse. But the nature of vanna is that it really becomes more of a hedging factor for market-makers when the Vix levels are already high. If you’re seeing low Vix levels, it’s not a risk they’re too concerned with hedging.”

Vix had traded as low as 12.5 just a month prior to the August 2024 vol spike, but had already jumped above 20 during the preceding week as stocks sold off amid political uncertainty and expected shifts in Federal Reserve policy.

Adding to the nervousness at the time, the Bank of Japan raised its key interest rate to 0.25% on July 31, triggering a mass unwind of the popular yen carry trade. US jobs data released a couple of days later came in more than a third lower than expectations. The following Monday, the Nikkei 225 tumbled 12%.

DeSimone at OptionMetrics adds that dealer positioning may have been an overstated cause of the 2024 spike, which occurred in pre-market hours when liquidity in the SPX options used to calculate the benchmark is extremely light.

That said, even closing Vix levels suggested an outsize reaction for a 3% equity selloff, with the index closing 15 points higher on August 5.

A choppy and range-bound S&P in recent weeks hasn’t been enough to trigger a dealer scramble for volatility. But traders are cautiously eyeing the busy macro calendar for potential triggers.

Markets cleared one such hurdle – Nvidia earnings – with ease. On August 26 the chip designer announced it had doubled second-quarter revenue at almost $100 million. Nvidia shares opened up 7% on Thursday, lifting the S&P another 0.5% higher.

The primary focus for many is the US Treasury market and whether Treasury secretary Scott Bessent’s plan to support the bond market by doubling government debt buybacks will rein in long-term borrowing costs.

On August 18, 30-year US Treasury yields hit 5.33% – the highest level for 19 years. Yields have since fallen below 5.2%. But any backup could provide a catalyst for an equity shock. Others point to escalation of tensions in the Middle East or a further jump in Japan yields as potential trigger points.

“We had a few percent drawdown over the last week and vols haven’t really responded so far, but if we were to see something a bit more pronounced, this positioning setup could compound the vol beta,” Diamond says.

“A drift lower may be less dramatic, as dealers would have more time to adjust their hedges, but in a material negative shock where something happens in a relatively urgent way, vols could catch a meaningful bid.”

Editing by Rob Mannix