Vague Security Linked to Stock Volatility Plunges 80 percent (VIX)

Volatility spike boosts options hedging activity

During the market implosion on Monday, you may have heard the word "volatility" quite a bit. In the aftermath of an unexpected volatility explosion, Credit Suisse is moving to terminate the VelocityShares Daily Inverse VIX Short-Term ETN (NYSEArca: XIV). "If you're going to play the short-vol game, basically the goal is to just stay alive and avoid any circumstance where things can go up in smoke in minutes".

Many are even looking for an opportunity to buy "short volatility" again using exchange-traded products (ETPs).

He shared on his Twitter account an old-school stereo volume counter showing the liquidity levels on the US S&P index futures contracts. The higher the reading, the more volatile the stock market. To professional investment managers, volatility is measured in multiple ways.

Generally speaking, if the VIX is below 20, we have a stable and lower risk market.

VaR-based models need to be reset across all asset-class strategies, forcing further de-risking over the coming days and potentially weeks, as heads of funds and heads of risk try to figure out how much their models are forcing them to "gross-down".

If this sounds like gambling, that's exactly what it is. Together with savvier investors, they've put nearly $6 billion into exchange-traded products tied to the VIX, with more than 65 percent of that cash flowing into funds or notes that bet against price fluctuations.

That's because the measure has peaked for the year in February only once during its existence - interestingly, the only other time was during the market's early 2016 upset. Stock prices follow earnings growth, and thus the stock market rises over time.

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"On the 30th, when February VIX futures went over March, that was my signal to get out and walk away because stuff gets out of control when the board goes backward", he said. It is literally gambling. Yet even this is a derivative of a derivative.

The Lyxor S&P 500 VIX Futures Enhanced Roll (Lux) UCITS ETF (LVO GR) tracks the S&P 500 VIX Futures Enhanced Roll Index. There is a huge problem with this, in that futures contracts constantly expire, and new ones are put in place. That's right - 17 cents.

"The long term expected value of your ETNs is zero".

You are not only gambling, then, if you hold this security, you are literally just handing all your money to the casino.

Investment bank Credit Suisse has the the biggest holding in the XIV ETN (exchange traded note), and calculations by ForexLive indicate the bank may be facing losses of $US500 million in connection with their position. In that case, of course, let's imagine that most of your book was long the market. However, if the primary driver was indeed the rebalancing flows (and short-covering) from investors who were short volatility, the good news is that it's quite possible the market will return to normal.

The XIV fell more than 80 percent and was down another 13 percent Wednesday. Thus, trading is frozen, and whatever value your share is at that time is what you receive.

Most of the other peaks have been concentrated around August and October, which have 36 percent of the annual highs. The firm for years has been calling for better regulation of leveraged products, with Chief Executive Officer Laurence D. Fink saying in 2014 that such offerings have a structural problem that has the potential to "blow up" the industry. They have no place in your portfolio.

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