Stocks

A Very Hot Bet Collapses

Between the first of January 2016 and 2018, the ProShares Short VIX Short-Term Futures (SVXY) was one of the most lucrative ETFs you could have owned.

Its price rose from US$18 to US$118 in just two years – a 555 percent gain.

Now, it trades for just US$12.65… all the previous gains (and more) were wiped out in a matter of days.

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There’s an old expression about the dangers of “picking up pennies in front of a steamroller”. That doesn’t quite apply here, because the gains from 2016 to 2018 were anything but pennies. But when you short (sell) volatility, you best know what you’re doing and what the risks are.

Sadly, many of the investors who bought into this short volatility product (and others like it), didn’t really understand just quite how quickly they could be wiped out.

So what happened?

Take a look at the below chart showing the past 10 years of data for the VIX (or CBOE Volatility) index.

The VIX is often used as shorthand in the media for concerns about the stock market. It’s a measure of anticipated market volatility.

The index is based on option prices of individual stocks in the U.S. S&P 500 index. When investors expect more price fluctuation (that is, for prices to bounce around more), the VIX goes up.

But as you can see below, volatility, as measured by the VIX index, has a history of bumping along a range before spiking up fast and furious.

We’ve seen it time and time again, so anyone shorting volatility (i.e. betting that the VIX would remain low) would be fine for a while… until they weren’t.

As you can see, the VIX has been on a declining trend since 2016 as equity market volatility remained muted. But you’d have to have your head in the sand to think that volatility wasn’t going to inevitably spike higher at some stage.

We warned about the risk of this kind of market correction last year. Specifically, we pointed out that despite the fact that the VIX was low, the CBOE Skew Index, which tells us how worried the market is about a near-term black swan event

“Far from saying everything is OK, this fear indicator is telling us the opposite… that the market is increasingly paying more for downside insurance against a black swan event. So there’s more concern about it.

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Does this mean that there’s going to be a sharp market correction tomorrow? No. SKEW has been trending upwards since 2008.

However, given that it is elevated and has just hit an all-time high, it does imply that the risk of a sharp correction is rising.”

As a former derivatives structurer, I realise I have a better handle on how synthetic volatility ETFs work than the average retail investor.

But the reality is these are sophisticated products. You need to have not just an understanding of what volatility is and how it’s reflected in the VIX index, but also the way that volatility futures are priced, what the shape of the VIX futures curve looks like, and what will happen if you stress test a spike in volatility.

You see, what most of these short volatility ETFs do is say, sell a one-month volatility futures contract. Let’s say the forward VIX futures level is 15.00, and the spot VIX level (the VIX index you see) is 10.00. This implies that the volatility term structure (i.e. shape of the futures curve) is upward sloping.

This makes sense. There’s a premium towards buying longer term volatility (i.e. equity market downside protection). So we expect the VIX futures prices to be higher as we go further out the curve.

Back to the ETF… It’s long a one-month VIX futures contract at 15.00. Assuming all else remains equal, over time, that one-month futures contract will turn into a three-week contract, then a two-week, then a one-week one. Eventually, it will expire and the ETF will “settle” the difference.

If you sell a one-month VIX contract for 15.00, and then buy back (or settle) at the spot price one-month later at 10.00, then you’ve made a profit.

[Note: I’m using a simplistic example here. Every short volatility ETF will have different index mechanics of how they short and cover/roll their underlying futures contracts.]

In essence, these ETFs are continually selling high and buying back low, in a systematic manner.

The problem is, when volatility spikes, the VIX curve will typically not only increase in absolute terms, but it will also invert. That means short-term volatility futures spike dramatically upwards. So now the ETF is short VIX futures that have gone through the roof.

As a result, these ETFs got wiped out as the VIX rose three-fold in just a couple of days earlier this month.

I have to say, it’s somewhat ironic that many in finance are so quick to warn about the perils of buying bitcoin, yet are seemingly fine with offering absurdly complex (and leveraged) short futures ETFs to retail investors…

In summary, shorting volatility (and that includes selling put options on equities) is a dangerous game if you don’t know what you’re doing. Most individual investors have no business whatsoever buying these kinds of ETFs.

If you are going to indulge, then please make sure you read and understand the underlying ETF index rules.