One fact that I have never seen explained in public media outlets is the fact that hedging can be a volatility driver. When an institution is short gamma or short convexity (convexity is the fixed income version of gamma) then they can perpetuate market moves.

From JP Morgan:

Today’s expiration of S&P 500 Options reduced total options open interest by 6%. As August options expired and the level of the S&P 500 dropped below most of the option strikes, 55% of S&P 500 options gamma disappeared. This may contribute to easing of the extreme realized volatility that we have seen during the past two weeks.

Let us explain a few sources of these “short gamma” positions:

1. Natural Protection buyers – Institutions and individuals that are long equity exposure buy puts as protection against market downside.  The market makers or investment banks that sell these puts have no natural source for the exposure so they end up with a naked short put position (gamma negative)
2. Levered ETF’s – Leveraged ETF’s end up reducing exposure when the market goes down and increasing exposure when the market goes up to keep constant leverage proportions.  This is negative gamma.
3. Insurance companies – Life insurance companies sell long dated exotic put options in Variable Annuity guarantees.  This exposure creates short gamma and short convexity exposure.  Within indexed annuity and indexed life products, they sell call spreads which effectively gives them short call exposure (short gamma).
4. Mortgage hedging – mortgage pass through securities shorten in duration when rates fall and lengthen in duration when rates rise.  This is due to the embedded short call option on each mortgage that allows mortgage borrowers to refinance when rates fall.  This creates a negative convexity exposure which requires a hedger to purchase duration (buy bonds) when rates fall and sell bonds when rates rise.
5. Any product with an embedded rate guarantee – many insurance products have  2-4% crediting rate minimums.  These are effectively interest rate floors that insurance companies have sold to policyholders creating a negative convexity position.

So in reality it is a demon of our own design.  These factors contribute to negative gamma/convexity hedging that create market volatility.  In turn, individual investors get scared and sell when markets fall….then the hedgers need to sell more.  On top of all this, high frequency trading programs take advantage of momentum in financial markets and contribute to the instability.

We call this all “financial innovation”.