This shouldn't come as a great shock, but humans are.... well, they're human.
That means that when events transpire, our emotional personalities frequently search for and connect with the stories of other people to help interpret the meaning of current and past events.
The recent selloff in global equities is a great example of a well-publicized event that affected many people around the world.
Headline-making developments in global equity markets are especially easy to identify with because financial security is such an important aspect of human nature in the modern world.
So while many of us suffered a little bit during this unexpected speed-bump in the financial markets, we also subconsciously (or consciously) yearned to better understand this event through the stories of big winners, and big losers.
In this particular case, one of the big losers has received an outsized amount of attention - that being the XIV. While its name and construction are rather complicated (Daily Inverse VIX ETN), the main thing to understand is that it performs well when volatility remains low and does less well when volatility increases.
It was built to perform in an inverse fashion to the VIX itself, so when volatility rises, the XIV declines.
And when the VIX explodes, apparently so too does XIV.
On Monday, February 5th, the VIX made its biggest one-day move in the metric's history, moving 116% and closing the day at 37.32. For comparison, the VIX closed trading on Friday, February 2nd at 17.31. During that move, the XIV dropped from a value that was above $100, to a value less than $10.
It’s important to remember that the VIX is never the cause of a market sell-off. The VIX merely measures one aspect of the effect, particularly the ongoing price of market insurance through implied volatility in S&P 500 index options.
Taking a step back, US equity markets have been in the midst of one of the longest rallies in domestic history (2009-2017), second only to the rally after World War II which lasted 131 months (1946 to 1957).
Throughout the last year or so, markets had been especially tranquil, with the VIX averaging its lowest level in 2017 of any other previous year on record. This included spending the most time ever at or below 10 in a calendar year.
Obviously, the financial world is nothing if not adaptable. In recent years, traders had been piling into short volatility strategies because that was what was working - including some that probably weren’t fully understood (i.e. XIV). Obviously, that came to a screeching halt on February 5th.
Due to the velocity of the move in VIX, traders that had leaned into high-risk short volatility trades through products such as XIV and SVXY got their faces ripped off.
XIV and some of its holders have since received quite a bit coverage because obviously, they suffered some of the most extreme losses. A worthy question is why any of this should come as such a surprise?
Volatility exploded, those with concentrated short volatility bets experienced a loss, some of them catastrophic. That's the cruel reality of financial markets - there are winners and losers.
It's fairly well-known throughout the financial world that leveraged and inverse ETFs and ETNs are high-risk products. Elevated risk often translates to outsize losses - that's the definition.
Imagine a hypothetical scenario in which it's reported that all cell phones cause brain cancer (I repeat, this is a hypothetical scenario). In that case, one can only image the carnage in the telecommunications and technology sectors. Certainly, there would be a clearly defined group of losers, just as there were at the start of February 2018.
It’s natural to feel sorry for any individual that lost money and/or their job due to recent market developments. However, when you are betting big on short volatility, at a time when it’s hovering near historical lows, the risks to such a position are well defined (not to mention extreme).
After it’s all said and done, the XIV isn't a martyr. It performed exactly as intended, including the termination event that was listed in the prospectus in the event of an 80%+ drop.
Learning from our mistakes, or those made by others, is one of the most important ingredients to a successful career in portfolio management. News and developments from early February 2018 certainly afford an opportunity for a great deal of that...
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.
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