Emerging Risks

The Volatility market move yesterday was unprecedented: an increase of 177% from 23.68 to 65.7. The spike was reversed intraday and the VIX closed at 38.57.

Extreme fluctuations like what we saw in the VIX yesterday create significant gains for some and significant losses for other clients.

(VIX index price movements on Aug 05, 2024 - Bloomberg)

What lessons should we learn from the spike?

1.      Data is king:

a.      Having been involved in a significant number of disputes that arise in these types of market dislocations from margin disputes to suitability to misrepresentations, we strongly recommend that you advise your clients to save all broker runs, pricing service data, and time stamped trade tickets with prices, just in case

2.      Whiplash risk is serious:

a.      Algorithmic trading is highly risky. Buying the VIX during the morning spike was catastrophic.

b.     Hitting risk limits that force liquidation is highly risky. Forced liquidation because of adverse market moves can be expensive. Risk limits need to take account of possible adverse events.

3.      Financial models are continuous; markets are discrete.

a.      You cannot trade continuously and should not assume that you can.

b.     Hedging must build in the possibility of discrete movements. Risk limits must take account of discrete moves or jumps in the market before you can re-hedge.

4.      Iceberg risk is serious, what you see may only be the tip of the iceberg

a.      One elephant-sized trade may not be unique.

b.     If one trader thought it was a good idea, there could be a herd out there.

5.      Scenario analyses need to take account of the unexpected          

a.      Take account of history so you don’t repeat the mistakes of the past, but

b.     Historical market maximums do not create a ceiling on future stresses, and

c.      Stress scenarios are an exercise in creativity to include the previously unexpected.