I’m seeing a lot of articles (e.g., here and here) warning about a possible short squeeze in volatility. At the risk of being a curmudgeon, it appears to me that people don’t know what a short squeeze is.
Sure, if you’re short something that starts going up rapidly (e.g., Achman with Herbalife), life is not good. There’s a positive feedback loop when people closing out their short positions have to buy shares to cover—which drives the security up higher. However this phenomenon is not so different than what happens on the long side when a security starts dropping rapidly; stop loss orders start triggering, traders start getting margin calls and panicky sellers drive the price down even further. In fact declines are almost always faster and deeper than rallies, but somehow we don’t see “long squeeze” in headlines very often—I guess “crash” or “panic” works well enough.
What makes a squeeze a squeeze is a lack of liquidity. A classic case occurred with VW in 2008 when Porsche unexpectedly bought VW, and ended up controlling 74% of the outstanding shares of VW.
With options, futures, and Exchange Traded Products (ETPs) market makers can usually provide additional long or short contracts or shares at will—obliging the market by taking the opposite side of the trade, which they usually hedge with other securities or in the case of ETPs create or redeem shares via the issuers. With company stocks it’s not possible for the market markers to facilitate share creation—the company itself must either issue additional stock, or sell shares it controls. In the case of VW, the amount of stock available to buy was so meager the price shot up 82% in one day, making VW’s market cap €300 Billion, the highest in the world—exceeding ExonMobile, the leader at the time for a day.
In the case of volatility, there is no “Volatility Inc.” out there. The only plays are futures, ETPs, and options—none of which require a company to go through exceptional measures to issue shares in order to provide liquidity. The VIX futures market is pretty big and VIX futures can be hedged with the S&P 500 options market—which is really big. The volatility ETPs are based on the VIX futures and benefit from that underlying liquidity and the options can be hedged a mind numbing number of ways.
It’s certain that traders short volatility will get hurt badly in the future by volatility spikes, but I think it’s unlikely a real short squeeze will materialize.
A sure sign of a true squeeze (or a flash crash) is abnormally wide bid / ask spreads—it indicates market makers are having difficulties hedging their positions. If you see that, then it’s time to be worried.