VIX Wagers Surge After S&P 500’s Best Start Since 1991: Options

Demand has never been greater for an exchange-traded note that appreciates when U.S. stock volatility rises, pushed up by speculators after equities posted their best start to a year since 1991.

The market value of the VelocityShares Daily 2x VIX Short- Term ETN, which aims to produce twice the daily return of the Chicago Board Options Exchange Volatility Index, more than tripled this year to a record $514 million. Issued shares rose more than sixfold to 33.8 million between Dec. 30 and Feb. 7.

Stocks have gained in 2012 following better-than-estimated jobs data, driving down measures of equity volatility. Now, after the Standard & Poor’s 500 Index rallied 7.5 percent, investors are buying the ETN in case the advance fizzles and price swings surge, said Glenmede Trust Co.’s Sean Heron. The VelocityShares security rose 135 percent in August after S&P cut the U.S. government’s credit rating, roiling markets.

“It’s a convenient way to own volatility,” Heron, who manages options strategies at Philadelphia-based Glenmede, said yesterday in a phone interview. His firm oversees $20 billion. “People want to own the VIX, people want to be long volatility and protect their assets.”

Increasing use of exchange-traded VIX products has driven volume and open interest for its futures to new highs. The futures have an open interest of about 190,000 and reached a record 248,976 in June. That’s up from an average of 179,253 last year and 91,481 in 2010, data compiled by Bloomberg show.

Record Swings

VIX swings widened to a record last year. The gauge’s three-month realized volatility increased to a record 191.59 on Oct. 31 as then-Greek Prime Minister George Papandreou said he would hold a referendum on the European Union’s bailout plan for the nation, boosting speculation the country would default. That was more than double the 92.09 median over the prior decade and eclipsed the prior peak of 190.44 from December 2008.

Yesterday, European finance ministers held back a rescue package for Greece in a rebuff that left lawmakers in Athens under government pressure to endorse a newly minted austerity plan or exit the euro. The refusal to deliver a 130 billion-euro ($173 billion) bailout for Greece reflected the euro area’s frustration with the country’s bickering politicians and the prospect that they may again backtrack on fiscal commitments not passed into law.

The VIX jumped to a two-year high of 48 in August after S&P reduced the U.S. government’s credit rating. Equity investors bought volatility products after enduring unprecedented price swings in 2011 when concern about Europe’s debt crisis pushed the Dow Jones Industrial Average to alternate between gains and losses of more than 400 points on four days for the first time ever in August. Daily share swings in the S&P 500 averaged 2.2 percent that month, the most for any August since 1932, Bloomberg data show.

‘Going to Explode’

“If we ever get volatility in the market again, those things are going to explode,” Dominic Salvino, a specialist on the CBOE floor for Group One Trading, the primary market maker for VIX options, said in a phone interview yesterday. “In a quiet market like this, people who want to trade an instrument that moves a lot are going to want to find something that’s leveraged.”

VelocityShares LLC, which is based in Darien, Connecticut, created its first products in 2010. Six exchange-traded notes tied to the VIX, which tracks the cost of using options to protect against a drop in the S&P 500, launched that month. The TVIX, as the leveraged ETN is known, was one of them.

Barclays, VXX

Shares issued on Barclays Plc’s competing iPath S&P 500 VIX Short-Term Futures ETN (VXX), the volatility-tied security with the largest market capitalization, have also increased, doubling since the end of 2011 to a six-month high of 38 million. The security is known as the VXX.

“Investors can use these products to gain exposure,” Tim Edwards, a vice president at Barclays in New York, where he’s responsible for ETN product development, said yesterday in a phone interview. “Some participants are viewing this as an attractive buying point.”

ETNs, which are unsecured bank debt, are backed by their issuer’s credit -- unlike exchange-traded funds, which hold assets. Banks create and redeem shares of ETNs based on the level of demand for the securities. That demand doesn’t affect the price since the ETNs track the performance of an index. Both the TVIX and VXX notes are based on the VIX futures.

Money for Lending

Banks issue ETNs to raise funds that they can use for lending or other purposes. London-based Barclays, which controls less than half the market, listed the first securities in June 2006. Money invested in the notes has increased to about $16.1 billion, according to data compiled by Bloomberg.

Without a surge in volatility, returns on the notes can decrease over time. The TVIX has declined 84 percent since its peak on Oct. 3 as the VIX tumbled 59 percent during the same period. Barclays’ VXX fell 55 percent while the S&P 500 rose 23 percent from its October low.

“Holding it for a long period of time is usually a bad play,” Joe Tigay, a VIX options trader at Stutland Equities LLC in Chicago, said in a telephone interview yesterday. “There is this rebalancing effect, where every day they have to recalculate it, and there’s a general bias” downward.

That doesn’t prevent investors from buying ETNs such as the TVIX, which offer easy exposure to volatility, said Michael McCarty, managing partner at Differential Research LLC in Austin, Texas.

“It’s become one of the favorite long VIX vehicles because it’s double-levered,” McCarty said in a telephone interview yesterday. “People want an easy-to-trade solution.”

To contact the reporters on this story: Jeff Kearns in New York at jkearns3@bloomberg.net; Nikolaj Gammeltoft in New York at ngammeltoft@bloomberg.net; Katia Porzecanski in New York at kporzecansk1@bloomberg.net

To contact the editor responsible for this story: Nick Baker at nbaker7@bloomberg.net

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