XIV ETF on February 5, 2018
The short volatility trade had become very, very crowded. Between XIV and its levered brother, SVXY, $3.3 billion had gone into these funds in just 1.25 months! To be honest, I am not entirely sure how the traders in the funds managed to put that much cash to work in futures markets over that period of time (though futures are more liquid than options). And, this is on top of the traders running the short vol trade in option markets.
First, it is important to remember that XIV and SVXY are inverse of the VIX index. So, when the VIX goes up, these funds go down.
So, when markets got choppy over the past week, and the VIX index spiked 80% during the day (on 2/5)—going from 17.95 to 40.00—these funds did the inverse of that. XIV went from $113 to $5.50 (a 95% loss), SVXY did about the same.
To protect the investors (and sponsor), the fund has a termination clause: an >80% spike in VIX triggers a liquidation procedure. This is because the traders need time and buying power to cover their trades. That clause was triggered in those funds, and traders began to unwind their positions.
There was some speculation that Credit Suisse, the sponsor of the funds, may have bailed them out, but no such luck. CS announced they were proceeding with the fund termination per the prospectus.
Let me be clear, for most investors, this is a side-market that doesn’t affect them much directly. However, for professional traders playing in these markets every day, this was a huge move, and it caught several flat-footed. Further, the fact that the fund is being liquidated means these losses are locked in, you can’t trade your way out of it.
Now, this does affect the average Joe, because the ripples are being felt in stocks right now. To fully understand why, you need to understand how these trades were built.
HOW THE TRADES ARE BUILT. The VIX index is not investible, but you can trade futures on it. To bet on a VIX spike, you have to buy futures. The problem is that this is expensive to do because the sellers of those futures need to be compensated for the sudden price spikes to which VIX is subject. You buy a 1-month contract for, let’s say $1, most of the time that contract expires worthless. You have lost $1. Do that over and over, and before long you are out of money. That’s why VXX (the long VIX ETN) looks like this:
This negative “roll yield” eats up any long term returns. That is why they specifically state that this product is for intra-day trading only.
However, if you take the opposite trade, and short those futures, you capture positive roll yield! This is what made XIV so popular, returning about 100% in 2017 alone.
But, as is always the case in finance, there is no free lunch. Extra return is always had from extra risk. It so happened that this risk was lurking beneath, unseen.
HOW THIS AFFECTS YOU. So, when these crowded and levered trades are unwound, market participants are forced to generate massive amounts of liquidity all at the same time. That creates heavy selling in liquid markets—like stocks.
Some of the recent selloff can be attributed to the unwinding of these bets (or at least the hedging of them, which involves shorting the S&P 500 index—further exacerbating the selloff).
In truth, for the long term, this is a healthy thing to do. After moves like this, the subsequent rallies can be much more fundamentals-driven (which are very good), and less based on temporary market structures.