As of Monday after the close, almost everyone knows what VelocityShares Daily Inverse VIX ST ETN (XIV) and ProShares Short VIX Short-Term Futures (SVXY) are. For those that do not, the two of them are inverse exchange-traded products (ETPs) of the iPath S&P 500 VIX ST Futures ETN (VXX) .
To many traders, owning these two ETPs made a ton of sense because VXX has historically lost a ton of money. While VXX was up big Tuesday, the split-adjusted IPO price for VXX is just over 107,000 dollars. That is how bad VXX has performed long term.
The trade almost seemed too easy -- and worked that way too. One year ago, XIV closed at about $62 a share; even on Jan. 31 leading into the dearth of earnings the ETN was up more than 100% year over year. By that Friday XIV closed at $115, up only about 95% year to year.
To the average investor who maybe doesn't understand the nature of XIV, why would it be worth closing this winner when it has performed so well? What was the risk? If I sell now, I'll probably be buying it back for $130 next week.
Here is the problem many investors do not understand: the risk of being an Inverse ETP.
If one reads the prospectus of XIV, there is a provision in it that states if the VIX futures index that it tracks, VXX.IV, is up 80% in one day they can shut down the ETP. SVXY, a similar ETP, has similar but less specific language.
The reason for this language is that they are inverse products. If VXX.IV goes up 100%, what is the inverse of that number? If VXX.IV goes up 130%, what is the inverse of that number? The answer is one can end up with a negative net asset value. Firms do not want that to happen and will generally do just about anything they can to make sure it does not. Therefore, as mandated in their prospectuses, these funds need to cover their short VIX exposure when the VIX is exploding higher.
This is where things went off the rails. Since most of these firms want to track as close as they can to the closing price of their tracking index most of them do not trade their underlying through the day. For the most part they execute what is called a "TAS," which stands for Trade at Settlement Price, the idea being that the fund will get settlement price and thus track their index.
Monday, with the VIX already up huge by 4:00 p.m. ET, XIV and SVXY looked at their books and had a very large amount of VIX futures to cover, about 200,000 (this is more than the average daily volume for VIX futures). That type of bid in the TAS book is going to cause VIX futures to move, at precisely the time that volume tends to lighten up. Thus from 4 p.m. to 4:15 p.m. the February began to tick up aggressively.
Based on the trading of these futures, VXX exploded higher (remember it tracks long futures) thus increasing the amount of futures XIV and SVXY needed to buy to cover, thus pushing VXX even higher. By 4:15 the Feb VIX future was up $10.00, a cool 43% move in 15 minutes. The VXX.IV index showed a daily gain of 96%. Thus, XIV if they were doing their jobs, should have showed a loss of 96%.
As of 1:30 p.m. Tuesday XIV announced that they are going to shut the fund down. SVXY, which apparently did not track their index well yesterday, is off about 84% from the close (and will stay open). What makes matters worse is that SVXY received $500 million of inflows on Friday. In addition, these funds are messing with some of the other indices and certainly the VIX futures and options themselves.
The aftermath of this and on the industry is rough. I have heard many stories about prop firms blowing up on the move SVXY made. I have spoken to retail traders that have taken a bath. And many of the top holders of XIV and SVXY are large wealth management groups. Even so, the total assets under management (AUM) for these names was only just over $2 billion, so how could they have that big of an effect?
The answer is that they were the stone thrown in a pond. XIV and SVXY affect the VIX futures, which effects movement in the VIX. Movement in the VIX (which is based on the price of S&P 500 options), leads to crazy trading in SPX options, which leads to selling of ES futures (S&P 500 futures), which cause the market to fall.
Normally, VIX is led by buying of options in SPX, which leads to movement in the VIX, which leads to movement in VIX futures etc. In this case the trading by these two firms was enough to reverse the ripple effect, causing two relatively small ETPs to send the whole market down 50 points after the bell and down as much as 115 points below fair value of the S&P 500 at its low point.
Over the next day I think this works itself out and eventually, with a little time, the VIX falls back toward 20 and then maybe lower from there. Next time, I will game plan how I expect to trade this market in VIX, VIX ETPs and the S&P 500.
This article was written with the assistance of research provided by Pravit Chintawongvanich, Head of Derivative strategy, Macro Risk Advisors and Michael Thompson CIO of Kaizen Advisory and D. Matthew Thompson, Director of Research Kaizen Advisory.
Mark Sebastian is a regular contributor to Real Money Pro, our site for active traders. Click here to get daily market commentary and trade ideas from Mark Sebastian, Paul Price, Doug Kass and many others.