VIX Tempest Plays Havoc With Volatility Notes Taking Futures Cue

  • Post-Brexit price swings have roiled exchange-traded products
  • Inverse ETN fell along with spot VIX on Monday amid turmoil

The market convulsions of the last week have been a lesson in the complexity of volatility markets for investors who bought exchange-traded notes tied to turbulence in equities.

Owners of the wildly popular exchange-traded securities have been whipsawed day after day as the benchmark measure for stock volatility bobbed and weaved in the aftermath of the U.K. referendum. Some of the moves were straightforward reactions to the up-and-down motion of the VIX, others a byproduct of less-visible currents in futures markets.

While nobody’s saying the notes malfunctioned, the swings show how hard it can be to win with securities swayed by markets as bewildering as the ones where volatility is traded. Those pitfalls have been no barrier to the securities’ acceptance: they account for half of the six most heavily-traded exchange-traded instruments over the past month.

“The violent volatility environment we’ve seen in the past week is a great reminder how difficult it can be to monetize these underlying positions,” Jim Strugger, a derivatives strategist at MKM Partners in Stamford, Connecticut, said by phone. “It’s hard to imagine right now that most people involved in these products made money over the last five days.”

Consider the IPath S&P 500 VIX Short-Term Futures ETN, a security that has seen more volume than any other exchange-traded product in America over the last 30 days except for State Street Corp.’s S&P 500 tracker. Long volatility, the note surged 24 percent the day after Brexit, and has since slumped 18 percent in a series of cascading steps. It fell on Monday even as stocks capped the worst two-day drop since August.

Over the past six months, in which the average level of the CBOE Volatility Index has risen 8 percent from last year, the note with ticker symbol VXX has dropped 31 percent. At the same time, it’s lured almost a billion dollars in fresh cash from investors. The note has slumped 20 percent this week.

“I don’t like these things and I don’t trade them,” said Steve Sosnick, an equity risk manager at Timber Hill LLC, the market-making unit of Greenwich, Connecticut-based Interactive Brokers Group Inc. “They’re embedded options, so each layer you get away from the original product means more variability. There are so many moving parts and hidden fees that ultimately make these products fluky and difficult to trade.”

One way to see how strange the products can get in times of stress is to compare daily moves in VXX with a security that should be its polar opposite, the VelocityShares Daily Inverse VIX Short-Term ETN, which is short volatility. On most days, the two securities’ price action is an almost perfect mirror image, which makes sense since one is long and one is short.

Andrew X. Smith, a spokesman for Barclays Plc, the issuer of iPath funds, declined to comment. A spokesperson from Janus Capital Group Inc., which owns VelocityShares, did not respond to a request for comment.

On Monday the securities not only moved in the same direction, but did so to a degree not seen since April 2013, Bloomberg data show.

The reason the normal pattern dissolved is that the securities aren’t actually designed to track the VIX -- they’re pinned to VIX futures, which in normal times move in accord with the spot index. These have not been normal times, however.

Monday in particular saw unusual relations at the surface of the volatility landscape. For one thing the VIX fell -- a lot -- on the same day the S&P 500 declined, something that almost never happens. VIX futures, on the other hand, rose moderately in the period U.S. exchanges were open -- the relevant period for ETNs that trade like ordinary stocks. As a result, while the VIX dropped, so did the note designed to pay the inverse of volatility.

“It’s definitely a better indicator to look at what the futures are doing,” said Mark Sebastian, trader and founder of Option Pit, a Chicago-based education and consulting firm, said by phone. “VIX futures can absolutely be the dog, not the tail, because that’s where the trading activity is.”

While ETNs linked to the VIX have been around for more than half a decade, traders still struggle to understand their mechanics, often to their own detriment, according to Strugger. For instance, even if an investor correctly identifies a price move ahead of time, they can still end up losing money if they don’t sell at the right time, he said.

“The vast majority of investors don’t have a great appreciation for negative roll yields, the shape of the VIX futures curve and the implications across all these products,” said Strugger. “There’s no question that there’s a significant lack of understanding among almost all investors as to how these products work.”

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