The "crack" in the calm U.S. stock market: VIX unexpectedly "soars in one day," leveraged ETFs may become a new hidden danger in the market

According to the Zhitong Finance APP, the U.S. stock market is currently not particularly turbulent, but it appears fragile. In the past two weeks, even though the S&P 500 index has remained relatively stable, the volatility index has experienced sharp rises and quick declines. This has reignited discussions about market fragility—long periods of calm have been interrupted by sudden and excessive volatility.

The latest example occurred on October 16. On that day, due to market concerns over regional bank loan losses, the S&P 500 index only fell by 0.6%, but the Chicago Board Options Exchange Volatility Index (VIX) surged to a six-month high. According to analysis by UBS strategists, the increase in VIX relative to the S&P 500 even exceeded the volatility events of August 2024, the "Volmageddon" of February 2018, and the situation following the collapse of Lehman Brothers in 2008. By October 17, the VIX quickly fell back to levels seen a few days prior—specifically, before U.S. President Trump unsettled the market with threats of imposing higher tariffs on China.

UBS strategists, including Kieran Diamond, pointed out that on October 16, the volatility positions held by market makers in S&P 500 index options became more "bearish" as the market declined, and when these positions were covered, it may have further amplified the surge in VIX. Additionally, traders may have held short positions in VIX call options, and the hedging of these positions also contributed to the rise in volatility.

Bank of America strategists stated in a report that the volatility on that day was more technically driven. VIX-related exchange-traded products (ETPs) may not have played a major role in driving the market, as investors took profits when VIX rose, while market makers covered their shorts. The strategists noted that with a 10-point rise in VIX futures in the previous month, only about 17% of volatility long investors needed to sell positions to offset traders' rebalancing actions.

This pattern of "calm periods suddenly interrupted by volatility" also highlights the market "pull" phenomenon caused by the massive growth of trading products. On one hand, there are funds that sell options to earn premiums, thereby suppressing volatility; on the other hand, there are leveraged ETFs that use swaps to track the returns of the S&P 500 index and the Nasdaq 100 index, or recently emerged leveraged funds that concentrate holdings in stocks that have the greatest impact on the index.

Garrett DeSimone, head of quantitative research at OptionMetrics, expressed concern about the potential risk of negative feedback loops triggered by the rebalancing of 2x and 3x leveraged ETFs when discussing the VIX surge on October 16: "When I think about the extreme volatility of VIX and the broader liquidity pressures associated with leveraged products, my biggest concern is the potential risk of negative feedback loops triggered by the rebalancing of 2x and 3x leveraged ETFs." Leveraged stock ETFs have become a hot topic of discussion, especially regarding individual stocks like NVIDIA (NVDA.US) and Tesla (TSLA.US) — these stocks are highly favored by retail investors. The focus of the discussion is on the market impact of these funds' daily rebalancing trades, which typically occur around the close, particularly during periods of high volatility and low liquidity.

According to Antoine Porcheret, head of institutional structured products for Citigroup in the UK, Europe, the Middle East, and Africa, the nominal size of global leveraged ETFs is approximately $160 billion, with the top ten stocks accounting for about 65%. In times of significant market volatility, the trading volume of certain single-stock funds can account for 100% or even 200% of the "closing market price trading volume," which "clearly affects prices." He stated that banks, as the ultimate counterparties for these funds through swap transactions, face approximately $300 billion in equity risk exposure due to leveraged funds.

However, this is not the only risk faced by banks. They are also exposed to what is known as "gap risk," which refers to potential losses incurred when facilitating these trades. For example, if a company announces bankruptcy, its stock price could theoretically approach zero, resulting in a 100% loss for a 2x leveraged ETF. In such a scenario, the hedged positions held by banks would effectively lose double that amount.

Banks typically hedge this gap risk by selling hybrid or standard derivatives to institutional clients. Unlike past crises, this type of risk does not linger on banks' balance sheets for long, unlike the large exposures created by holding variance swaps and other derivatives during previous crises.

Today's risks resemble "one-day vulnerabilities." In the current market landscape, long periods of calm are often interrupted by flash crashes and rapid rebounds, which can leave some participants injured. Garrett DeSimone stated, "I see several potential contagion risk channels. Leveraged ETFs now manage a massive asset scale, a significant portion of which is concentrated in the technology sector, and tech stocks themselves hold a considerable weight in the S&P 500."