Lessons From Bizarre Trading Stories

 | Mar 29, 2012 | 11:45 AM EDT
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This article first appeared on ETF Profits.

I've noticed a couple interesting stories related to execution of ETF trades in recent weeks, and wanted to take the time to explain a bit further in order to teach a couple of valuable lessons to investors. Unfortunately, both involved the destruction of a significant amount of money in a very short period of time.

The first relates to the VelocityShares Daily 2x VIX Short Term ETN (TVIX), a product that offers amplified exposure to a benchmark comprised of futures contracts on the CBOE Volatility Index (VIX). TVIX was in the spotlight recently when Credit Suisse decided to suspend creation of new shares, effectively limiting the demand of this exchange-traded product. Demand for exposure to the VIX remained strong, so TVIX started trading at a premium to its net asset value -- a relatively common occurrence when creations of a popular product are suspended.

Then, seemingly all of a sudden, the significant premium began to disappear. TVIX lost almost 30% last Thursday -- when the underlying index was up -- and dropped another 30% Friday after Credit Suisse announced it would resume creations. (The big decline on Thursday would seem to indicate that news of the resumption of creations had leaked.)

The sudden free fall of TVIX erased hundreds of millions of dollars in assets in a matter of days -- a catastrophe for those who held positions in this ETN. But don't shed a tear for any investors that got the short end of the stick on this one, because they weren't investors at all. They were speculators playing a dangerous game -- one that ultimately got them burned.

Anyone interested in leveraged exposure to volatility had a nearly identical option available to them in ProShares Ultra VIX Short-Term Futures ETF (UVXY), which seeks to deliver 2x daily exposure to the same index to which TVIX is linked. That means anyone who elected to use the ETN instead was willing to take on the risk that comes in holding a security at a big premium to its NAV. Again, that's not investing. It's speculating. Many investors profited as the premium continued to inflate, then incurred some quick losses as the bubble burst.

There is, of course, a lesson here: Tread very lightly around funds trading at a premium to their net asset value. These types of products tend to attract highly sophisticated investors --and when you go swimming with the sharks, you often end up getting bit.

Another fund that saw some interesting activity last week was a newcomer: the Yorkville High Income MLP ETF (YMLP). After debuting to strong investor interest -- the ETF traded more than 50,000 shares during its first session -- things got interesting when a few trades were executed at bizarre prices. A few hundred shares of YMLP changed hands at a price that was more than 50% above recent transactions.

So, in a scene reminiscent of the flash crash -- but in reverse -- subsequent trades occurred at prices much closer to the actual NAV of the fund. Upon further review, the trade was not cancelled since it was determined that this wasn't caused by any mechanical error but, rather, a foolish investor decision. The result was unfortunate for whoever was on the "buy" end of that transaction: Someone paid about $3,000 for 100 shares of YMLP, which were immediately worth only about $2,000.

There is a lesson to be learned here, as well, and it's one that I've tried to convey before. Market orders and ETFs are a dangerous combination that can lead to unfavorable execution, and they can cost you quite a bit of money in a matter of seconds. When you put in an order to buy a security at whatever price the market will bear, you're opening yourself up to the opportunity of paying a big premium to NAV.

Fortunately, the solution to this type of potential headache is both cheap and easy to implement: limit orders. Had this unfortunate investor utilized a limit order, the trade would have gone off at a price much closer to surrounding trades.

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