I got a question on Twitter today about the potential for a volatility short squeeze. I think the question was rooted in how much activity and open interest there is in volatility oriented derivatives, but the instance I recall that felt like the move was overdone occurred in late 2012.

As the end of 2012 approached it appeared that the President and Congress were at an impasse over extending the Bush Tax Cuts from 2001. The pending result was commonly referred to as the ‘fiscal cliff’. Financial markets were very concerned and the S&P 500 lost 3% between December 18 and December 28. Over that same time period VIX rose over 30% from 15.57 to 21.79. The chart below shows VIX and the front month January 2013 VIX Futures contract from December 3, 2012 through January 16, 2013 (expiration date).

VIX Squeeze

Note the area I have highlighted with the purple box above. That is when the fiscal cliff news dominated the markets and caused a spike in VIX. Usually the front month futures contract, especially where there a couple of weeks remaining to expiration, will not move in sync with a spike in VIX. This was not the case with the fiscal cliff and one of the theories is that this piece of news coincided with the year coming to an end.

Here’s the theory. Make sure to use Billy Ray Valentine’ voice as your narrator. There’s a couple of days left to the end of the year and you work for a hedge fund. One of your strategies that worked so well in 2012 was being short VIX futures playing the drift down the curve to spot VIX into expiration. You look up at your screen on December 28th, and you see VIX moving higher, you are short January futures and the futures aren’t acting like they are ‘suppose to’, that is lagging the move in spot VIX. Your year-end bonus and performance is quickly going downhill. Maybe you jump in and cover your VIX futures short and salvage what is left of your year.