Finance

Investors who bet on calm stock markets lose out as volatility returns

Investors who bet on calm stock markets lose out as volatility returns

One of the hottest trades in recent memory, shorting volatility, evaporated in a heartbeat Monday.

VIX call options, primarily used to protect against a spike in volatility, accounted for nine of Monday's 10 most heavily-traded contracts. Stock markets had advanced double-digits previous year and were up another 8 percent in January.

Kristina Hooper, chief global market strategist at Invesco, said there were "a lot of forces at work", but the short volatility trade blowing up "certainly aggravated it".

Credit Suisse announced a redemption of its Vix short-term exchange-traded note later this month after the rise in market volatility led to the note losing more than 80 per cent of its value, triggering a clause allowing the Swiss bank to shut it down.

The ProShares Short VIX Short-Term Futures ETF (SVXY), which had $2.2 billion in assets last week, saw its net asset value decline by 96.1% on Monday. That suggests retail investors could own a sizeable chunk of the volatility product which booked a 585 per cent gain for the two years ending February 1. "Wall Street will invent anything to provide a casino for people to speculate until it blows up".

"That was a very crowded trade, full of people who didn't understand the products", said Sal Arnuk, co-founder of Themis Trading and co-author of the book "Broken Markets". In October, it ordered Wells Fargo to pay investors $3.4 million for improper sales of the products.

Volatility is key to the investment decision of these programmatic funds often employed by pensions and insurers - a specific level is set, and leverage will be adjusted to maintain that objective depending on how much each asset class swings. Credit Suisse AG - VelocityShares Daily Inverse VIX Short Term ETN has a twelve month low of $5.50 and a twelve month high of $146.44.

The strategy requires constant trading in VIX futures to keep on track, but it's not a strategy that works long-term.

Ultimately, if you do want to smooth out those ups and downs, you'll need to be diversified, hold at least some uncorrelated assets and make sure to invest according to your risk tolerance.

Long volatility products, on the other hand, experience decay in value due to contango.

The VelocityShares ETN was down 94 percent Tuesday afternoon. As the sponsor of the VelocityShares note, Credit Suisse had the right to wind down and liquidate the note if its value changed more than 20 percent in a day. Investors are anxious about how the failure of some products created to short the VIX index will affect Cboe Global Market's VIX-related volume, revenue, and ultimately, its earnings. He warned that a "sudden eruption" of volatility could leave traders "badly burned". Barclays, Goldman, and JPMorgan Chase & Co. have each warned of a wave of equity selling - with estimates as high as $225 billion - in the coming days in response to Monday's mayhem, primarily as a result of trend-following strategies or target-vol funds paring down risk.


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