VIX Gamma Squeeze

VIX (implied volatility on 30-day S&P500 index options) is at March 2020 levels this morning. There are a lot of shops who were shorting vol that have now blown up, so it's a good time to recap some of the mechanics and feedback loops likely driving this:

First recall that options buying drives implied volatility up and thus options prices up, not the other way around. Similarly, options selling drives implied volatility down and thus options prices down.

Gamma measures how quickly the delta of an option changes in response to a one-point move in the underlying, and delta measures the sensitivity of an option's price to changes in the underlying.

In this case, the "underlying" is the S&P500 volatility index (VIX).

The options market, unlike the stock market, is not an exchange. Options traders will buy and sell through market makers (dealers), who then are mandated to hedge out their risk by maintaining delta-neutral positions — this requires dynamically adjusting their holdings of an underlying in response to changes in options prices and movements in said underlying. In this case, the underlying is VIX.

To illustrate this, think of a micro example;

Let's say a dealer is short 10 out-of-the-money (OTM) VIX call options with a position delta of -20 each. This means the dealer has a net short position of -200 shares (10 options * -20 delta each) and so, in order to remain delta neutral, will buy +200 shares of the VIX.

Now, if there's a sudden unexpected increase in the price of the VIX, the delta of the calls will become more positive. This means that the dealer's position delta will become more negative (he sold the calls), leading him to buy more VIX to delta hedge against the rising delta. The dealer bid under VIX contributes to further price increase, and as these call options (which were initially OTM) pick up moneyness, they will move closer to at-the-money where they pick up delta most rapidly — at peak gamma.

As the price of the underlying (VIX) rises, more call options move further in the money, leading to more dealer delta hedging and more buying of those options. Also, as more VIX is bought to hedge, the upward momentum is amplified, creating a positive feedback loop known as a gamma squeeze.

At a certain point, the volatility shorts (namely short vol ETFs) would in theory become overwhelmed and quickly puke the trade.