Monday August 5 2024, the market was closed for business for a couple of hours because SPX Options spreads reached ridiculous levels

• It was brutal but in a sense an illusion for most people
• Key Points
• The VIX and its two sister indices VWA and VWB
• When forced trading is like lighting stacks of $100 bills on fire?
• Aug 5, 2024 in comparison to other events
• Conclusion
• Addendum

It was brutal but in a sense an illusion for most people

Key Points

• It is possible to use the VIX to measure if the market is open or closed
• Monday’s disruption effectively closed the SPX Options market. It was one of the most intense disruptions ever.
• It became very difficult to know the correct pricing of portfolios in this state - particularly anything that requires a vol surface to price.

The VIX and its two sister indices VWA and VWB

There is not a single market professional nor retail investor that has not heard of the VIX. Most understand that it is related to the volatility of the market. Some understand exactly how it is calculated with strips of SPX options to replicate a variance swap. Few, and I mean very few, understand that it has two extremely important sister indices called VWA (Ask-Side VIX) and VWB (Bid-Side VIX).

As their names imply, VWA is calculated from the Ask-Side of SPX options and VWB is calculated from the Bid-Side of SPX options. The key point is they are exactly the same options that, at any given moment, are entering the VIX calculation. Typically, the VIX itself is right in the middle of the two.

In a healthy and open-for-business market, all three indices are very close to each other, typically differing by a fraction of a VIX point. This is what VWA - VWB looked like Friday, August 9. (I know it’s so close to the bottom you can barely see it. That’s the whole point.)

However, as volatility increases, the spread between VWA and VWB widens. This is simply due to the fact that options market makers are demanding a higher fee to provide liquidity - fair enough. Even in a high-vol market, there is not a problem because the market makers can lay off their risk in a multitude of ways.

But what about when things get so out of control that market makers step away? By step away, I mean make the bid-offer spreads so wide that it becomes nonsensical to trade because crossing the spread becomes the same as lighting a stack of $100 bills on fire.

When forced trading is like lighting stacks of $100 bills on fire?

In the chart below we see a few extreme events where the market was effectively shut for business. What we are looking at is the difference between VWA and VWB every minute since Jan 1, 2008. Values north of 15 or so means it’s impossible to trade SPX options at a reasonable price - hence the $100 bills up in flames if you are forced to trade.

Let’s go through them left to right

1. GFC in 2008. In the minutes of it’s peak there was nothing you could trade without paying a huge price Even E-Mini futures. Note it is over 40 VIX points of uncertainty as to the true level of the VIX. Not only was it virtually impossible to trade at that moment but it was completely impossible to know the value of a book of OTC derivatives.
2. The Flash Crash in 2010. It was short lived but brutal. The exchange busted many trades. Talk about a rude awakening from a PnL perspective and risk perspective to learn your trade was canceled.
3. 2012 had a bad hair day compounded by
• Eurozone Debt Crisis
• US Fiscal Cliff Concerns
• Global Economic Slowdown:
4. In 2015 we had: “On August 24, 2015, the U.S. stock market experienced a dramatic and rapid decline at the opening bell, with the Dow Jones Industrial Average dropping over 1,000 points within minutes. This event was driven by a combination of factors, including concerns over a slowing Chinese economy, uncertainty regarding the Federal Reserve’s interest rate policy, and overall global economic instability.”
5. Then came Volmaggedon in Feb 2018 when short-sellers of vol suddenly learned selling isn’t free money and those that were long VIX Calls had no liquidity to sell into despite sitting on huge paper profits.
6. Then Covid - Say no more
7. Then August 5, 2024.

Aug 5, 2024 in comparison to other events

• The most significant thing was that in each of the other events the market was down “a lot” - like 10% or more. On the 5th it was down less than 5%
• August 5th most resembles Volmageddon in its speed and time to recover but it was actually much more of a blow up. This is no surprise. While Volmageddon was limited to those exposed to VIX Futures through the XIV ETN that blew up that day, August 5 was a macro event that shook the core of a JPY carry trade that had been bread and butter financing for a very very long time.

Conclusion

There have been a number of events since 2008 where the market basically ground to a halt. Sometimes it was very short lived like the Flash Crash. In an event like that there is not much feedback into other parts of the market or the marking of OTC positions. In other instances where the event is protracted throughout one or more days the feedback can be far and wide and the uncertainty of where an OTC portfolio is valued can be huge.

Addendum

Of course, if you are long gamma or a liquidity provider, these events may have been some of the best days of your career. Instead of lighting stacks of Benjamins on fire, you were catching them as they were falling from the sky.