As trading opened on Monday, February 5th, 2018, stocks had already been falling for a few days. Then on that day there was a major decline – the largest drop in point terms in history. The Dow was down 1,175 points. The S&P 500 Index ($SPX) was down 113 points. All other major stock indices suffered similar fates. Those net changes were effective as of the 4 p.m. (Eastern time) close of the NYSE.
Volatility rose, of course. $VIX was up 116% on the day – rising from 17.31 to 37.32. $VIX trades until 4:15 pm Eastern, and the last three points or so of its rise came in the 4:00 to 4:15 time period. The $VIX futures were up substantially by 4 p.m., too, although not quite 100%.
However, as bad as those things were for the U.S. stock market, none was catastrophic for any product as the clock moved to 4 p.m. After 4 p.m., the rebalancing for the various Exchange-Traded Products (ETPs) takes place. In particular, the “short volatility” ETPs – XIV and SVXY – were about to undergo life-changing events. XIV had last traded at 99 and SVXY at 71.82, just before 4 p.m. By the time that $VIX futures had stopped trading at 4:15 pm, both products were in ruins. The Net Asset Value of XIV was about 4!
This demise of the “short volatility” strategy has triggered even more selling in the markets, and its after-effects may extend deeper and last longer than many had expected. The virtual hysteria in the media – even from supposed derivatives experts – has been almost comical. One vociferous commentator made the outrageous statement that, “Nobody understands these products, not even the people who own them.” That certainly is not true, but it may be true that some of the traders left holding the bag on that last day may not have understood exactly what was going to happen – mainly because they had not done their research.
We had previously written several articles outlining how dangerous a volatility explosion would be for XIV and SVXY. The primary such article was in The Option Strategist in the September 1st, 2017 edition (“Will the Short Volatility Trade Ever Disappear?”). There have been many other, similar articles by many other authors in the last year or so, mostly on web sites that are into things that are a bit more sophisticated...
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