Why is a High VIX a Signal of Market Liquidity Risk?
To answer this question, we must first understand what a single put trade means for a put seller.
The Structural Advantage and Risk of a Put Seller
For a put seller, statistically speaking, the market tends to rise most of the time. That means most out-of-the-money (OTM) puts expire worthless. Just like an insurance company, the profits of a put seller come from a large volume of contracts that don’t result in payouts — and the gains can be substantial (though, as we’ll soon see, so can the risks).
Unlike long puts, short puts are positive theta (they earn money as time passes), positive delta (they gain when the market rises), and negative vega (they lose when volatility increases). In calm or rising markets, it’s like picking up pennies every day. But when markets fall or volatility spikes, selling puts can lead to losses. So, small-probability events aren’t a big deal, right? (We’ll see if that’s true.)
Market Makers’ Hedging Mechanism: Delta Hedging
Insurance companies often transfer their risk to reinsurers. Similarly, market makers who sell puts need to hedge their risks. But unlike insurance, financial markets don’t allow perfect actuarial modeling of the underlying.
To hedge downside risk, market makers typically sell stock index futures in proportion to the delta of the puts they sell. This makes their position delta-neutral — market neutral — and lets them earn premium decay (theta) over time.
For example, if the market drops 100 points, a -0.3 delta put would lose 30 points per contract. But the market maker, who hedged by shorting 0.3 contracts of index futures, would gain 30 points from the hedge. Net result: no loss, and they still keep the premium. This is called delta hedging, and the hedge ratio must be adjusted dynamically as time and stock prices move.
Positive Feedback Risk: A Self-Unstable System
Market makers are often the smartest players on the street, but even they sometimes rely on simple — and risky — strategies like delta hedging.
Delta hedging is, in essence, an infinite risk options strategy. Its biggest flaw, in academic terms, is that it’s a positive feedback, self-unstable system.
A familiar example of a positive feedback loop: during a Teams meeting, if someone places the microphone near the speaker, it creates a loud, high-pitched feedback loop.
A very similar phenomenon can happen in financial markets because of put option dynamics:
- A market maker sells SPX puts. The puts have a negative delta (e.g., -0.3), so the maker’s account becomes positive delta (+0.3).
- To stay delta-neutral, the maker sells 0.3 futures contracts or equivalent stocks.
- If the market drops further, the put’s delta increases in magnitude (e.g., -0.5), so the maker has to sell even more futures, triggering more downward pressure on the market.
- This creates a feedback loop — market drops → more hedging → more drops.
The Squared Relationship Between VIX and Put Exposure
An important point: the relationship between VIX and put exposure is nonlinear — it’s squared.
Let’s use a simple assumption: if overall market positions stay constant, then a 10% increase in VIX can lead to a 20% increase in the notional value of all near-term open puts.
Option sellers must hedge this increased exposure by selling more futures. This is why a rapid spike in VIX from low levels is especially dangerous — if VIX triples, the required hedge size grows ninefold.
Margin Pressure and Liquidity Drain
As the market falls, demand for puts rises, increasing open interest. VIX goes up. Both negative delta and negative vega risks of puts become realized. Market makers now face soaring margin requirements.
Eventually, as their books deteriorate, market makers are forced to liquidate anything they can sell for cash. Other hedge funds and momentum-driven strategies also start selling. The sell-off reaches a climax, bid-ask spreads widen, and buying/selling becomes extremely difficult. (Think of the scene in The Big Short, where the two-man fund nearly couldn’t sell their winning short position — that’s not fiction.)
At this point, the market faces liquidity exhaustion: sellers are bankrupt, buyers disappear. If the government or central bank doesn’t step in, New York starts raining people. This kind of breakdown has happened before. Let’s look at a real case in March 2020.
Case Study: The 2020 Crisis
Although COVID-19 emerged in China in late 2019, the U.S. market didn’t react strongly until mid-February 2020. News of rising deaths, governmental failure, and disinformation shocked the market. By late February, a steady decline began. The market, barely recovered from the 2018 bear phase, was hit hard again. Put sellers who had sold cheap contracts when VIX was at 13 in mid-February now suffered massive losses. As markets declined, they were forced to short futures and ETFs en masse. S&P 500 futures (ES contracts) saw daily trading volume spike to over 4 million, a 267% increase. This drove the index down even more and pushed VIX higher. Even gold was sold off to meet margin requirements.
By early March, VIX reached 36. (Remember: a 3x VIX spike implies 9x hedging demand.) Such high volatility levels triggered Volatility Control, CTA, and Risk Parity strategies to also start dumping positions. By mid-March, VIX spot reached 82 — near all-time highs.
Finally, the Federal Reserve stepped in. Unlimited quantitative easing (QE) was announced. The Fed began direct bond purchases and injected liquidity into the banking system. Only then did markets begin to stabilize.
Conclusion: Why Selling Options Is a High-Risk Activity
By now, you probably understand not only why the VIX is a key indicator of market liquidity, but also why selling options is considered a high-risk strategy — regardless of how often it seems to work.