Odd Lots - How One Of The Most Profitable Trades Of The Last Few Years Blew Up In A Single Day

Episode Date: February 19, 2018

In recent years, one of the easiest ways to make money in this market has been to bet on low volatility. Up until recently, markets have been exceptionally tranquil, and trades predicated on that tranquility continuing have made a fortune. But two of the most popular vehicles for making that trade, XIV and SVXY got obliterated in one day in early February. On this week's episode of the Odd Lots podcast, we speak to Pravit Chintawongvanich, the head of Derivatives Strategy at Macro Risk Advisors about the episode. He explains what the short volatility trade was, how specifically these funds operated, and how they ultimately became victims of their own success. See omnystudio.com/listener for privacy information.

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And I'm Joe Wisenthal. Joe, I'm so excited. This is totally my topic. And I'm so, so excited that we're going to be discussing it for at least like 20 or 30 minutes. I like how you pretend that we never talk about anything that you like. You know, if you wanted to, you could contribute more and suggest more guests if you thought it was really that skewed towards things I like. Okay, okay, I'm exaggerating a little bit. But the reason I'm so excited is we're, first of all, going to talk about something that we have talked about on this show before in what was an excellent episode.

But secondly, we're going to talk about something that I've been writing about for years. And actually, a lot of other financial journalists and financial analysts have been writing about the same thing. And then earlier this month, it all happened. Everything that people had been talking about saying might happen for years actually happened. And it was a huge, huge event in the market. A, it's kind of rare for us as a podcast to actually be talking about something that's very timely. We're usually a little more off the news, so I'm excited about that. True.

But what's even rarer is for something bad to happen that financial journalists actually predicted, because we're usually pretty bad at that. Now, now. financial journalists are your friends and colleagues, so you should be nice to them. Financial journalists are good at calling 10 out of the last two crashes, as they say. Okay. All right. Well, on that note, let me set the scene.

So what I'm talking about is something that has been since dubbed the Volpocalypse, this big spike in volatility that we saw in early February. We had a sell-off in stocks, and then we had a spike in something called the Volpocalypse. index known as the VIX. Some people refer to it as Wall Street's fear gauge. Some people feel very strongly that it shouldn't be called that. And then as the VIX was spiking, we had two products that were tied to the index that encountered a tremendous amount of pain. One of them basically died that day. And the other one is sort of limping onwards. And just before we start the show, I'm going to throw out the full names of both products so that people know exactly what we're

talking about. The first one is the pro shares short VIX short term futures ETF called the SVXY. And the second one, the one that actually died, is called the Velocity Shares Daily Inverse VIX short term ETN. Say that two times fast. That one is known as the XIV. I am very excited about this conversation because as we've talked about, A, we talked about the short volatility trade on the show with the guests that we're about to talk to. So this is a follow-up. It's a story and then conclusion. And B, the backdrop to many of our episodes has been, it's like, Tracy, there's not much going on in the markets these days is low volatility.

So this really has everything for us, and I'm excited to get started. Yeah, finally, we can say that something happened in the markets. So without further ado, then, let's bring on our guest. He is, of course, Provit Chintowong Vonnich. He is head of derivative strategy over at macro risk advisors, and he has been writing about this. for years. Provit, thank you so much for coming on. I know you've had a busy week. Thanks for having me. So maybe just to begin with, shall we do a quick recap of what exactly the short volatility trade was? So I noticed you used the past tense. I don't think it's over yet for what it's worth,

but the short volatility trade, you know, so these two products that you just mentioned, XIV and S Vixie, there are just really two expressions of the short volatility trade. But more broadly, what does it mean to be short volatility? Honestly, it depends on who you ask. So if you ask someone like Chris Cole over at Artemis, he'd tell you that, well, all forms of risk taking are short ball. And I kind of agree with that view of the world in the sense that, okay, if you're long equities or you're long, you know, high yield credits, I mean, you're kind of short vol, right?

But let me dive into what most people are the kind of the more narrower, more common definition of short vol. Really what it means is to be short options, right? in order, other words, to have sold options. So think about what options are, okay? They're financial products that essentially will pay out if the reference asset, let's call it a stock, if it moves above or below a certain strike price, right? So in other words, if you own options, your long volatility, you want things to move, right?

The more things move, the more volatile things are, the more valuable those options are going to be. And likewise, if you've sold options, then you're short vol and you're earning that risk premium, right? So in other words, if you've sold options, if you're short of all, you want the markets to basically not do anything. You want the markets to be placid and kind of just go along and not do too much. And you're going to be paid for that risk premium, right? Think about, okay, so essentially options have what's called risk premium embedded into them. In other words, we don't know what's going to happen in the future. The future could be very volatile or it could be not so volatile, right?

So people price in what's called an implied volatility. In other words, in every option contract, there's basically, let's call it an expected volatility that's baked into it, and it usually trades a little premium to how volatile the market has actually been, or what people in the field is called realize volatility. So basically, if you sell volatility, you're basically betting that things are going to continue as they have been. In other words, the future remains like the past. And over the past year, in 2017, this was incredibly profitable trade because not only were the the markets not very volatile, they were actually less volatile than they had been and very much

less volatile than they had been for a long time. So as you stated, there's multiple expressions of the trade short volatility. There's the broadest view, which is that any sort of long investment is implicitly short volatility. You could go out in the options market directly and sell options. What really seems to have captured people's attention and the sort of fascination of the media, lots of people was these specific products that Tracy and you already mentioned, and all these retail investors coming in and pressing a button that says short volatility, because it's not

easy for the average person to sort of select a bunch of options to sell, as you put it, but it's very easy to just buy this ETF that says short volatility. It's as easy to buying a share of Microsoft. And just buying these ETFs or ETNs has been extraordinarily profitable up until very recently. Extraordinarily. I mean, the XIV was up almost 200 percent. in 2017. There's actually a funny story from Paul Britton, who's the CEO of Capstone, and he was basically saying that he was taking an Uber, and the driver was telling him about, oh, hey, there's

this great new company. You know, it might be a biotech or, you know, some kind of tech company. I don't know what it is, but it's up 80%. And he said this company is called XIV, you know, and Paul was like, mate, I'm sorry to tell you that's not a company. But, yeah, like, that just goes to show you, I guess, how widespread and popular the short vault trade had gotten. Yeah, the retail.

aspect of these products is amazing. You mentioned that Cab anecdote, but there was also a dedicated Reddit forum all about trading XIV. And if you go look at it right now, it's just full of horror stories of people that lost money. But before we get to that, Providence, can you walk us through exactly how these two products expressed their short volatility bet? Right. So both of these products were essentially short, what are known as VIX futures. So So what is the VIX? Well, you mentioned that it's sometimes called the Wall Street's Fear Gauge or whatever. Basically, the VIX is an index that's calculated using one-month options on the S&P 500 index.

So they basically, they take pretty much every one-month option on the S&P, and they take the implied of all those options and compress it into one handy number that you can look at on the screens. And VIX futures are traded contracts that are tied to the VIX index. So the VIX index itself, you can't trade, right? it's just a number that's calculated. But VIX futures, you can trade. And the idea behind VIX futures is like, okay, any futures contract, there's some kind of reference asset or index. And when the VIX future settles at maturity, it's going to settle to whatever that index is

on the day of settlement. So VIX futures basically allows you, in a sense, a way of trading the VIX, although it's definitely not the exact same thing. And so similar to how I mentioned that options have risk premium baked into them, VIX futures also have a risk premium that's baked into them too. There's, you know, uncertainty premium about what's going to happen in the future that causes VIX futures to generally trade at a premium to the spot. So to illustrate for you, imagine that the VIX spot is 12. Well, then the front month future might trade at, I don't know, 14 and the feature after that might trade at 16. And if I go and sell those features and nothing happens and the VIX spot remains 12, well, then the future will slowly convert to 12 and I make money. That's, in essence, what these products were doing. And so, you know, without getting too technical, although actually we're pretty into getting technical, so I don't know why I even said that. Joe, let's get technical. Now's our chance. Come on. Yeah, yeah. We're here to get technical on Adelot. Before we get into how it all blew up, which we're going to get to in a moment. Tell us a little bit about this idea. Futures have a forward curve or a term structure. And so out months tend to be, have more embedded risk premium into them than the in months. And this also provided juice to the trade, correct?

Exactly. How did that help the trade? So Joe, as you mentioned, VIX features have, you know, what's called a term premium to them, right? So if the VIX spot is at 12, then the front month future might trade at 14 and the future after that might trade at 16. And if the world remains the same, okay? So if the Vick spot just remains at 12, that means that if I go and sell that future at 14, eventually it's going to go to 12. If I go and sell that, you know, back month feature 16, if nothing happens, for the next two months and VIX spot remains unchanged, it should eventually go to 12. So there's this kind of term premium or kind of uncertainty premium that's baked into VIX futures. So let's jump to Monday, February 5th. So PRAVET between 4 and 415, we have this big move in VIX futures. And really the key to understanding why that move happened is to delve into the mechanics of exactly how these two products operate and how they deliver returns for investment. and it's worthwhile. I'm sure you'll remind everyone, but these products offer inverse leverage

to the VIX, and they offer a certain amount of inverse leverage. So walk us through exactly how those products do that. Exactly. So I think the key to understand these products is that they're leveraged. Both of these products offered the daily inverse return of essentially what one-month VIX features were doing, right? So if VIX features are up 10%, these products are down 10% and vice versa. So you can imagine, well, what if fixed features are up more than 100% that's going to be a problem, right? And we'll get into that later.

But another super important aspect to this whole blowup is what we call the rebounds, or essentially how these products were forced to trade into the clothes every day, right? So any levered product is going to have to buy the underlying on the days when the underlying is up and sell the underlying on days when the underlying is down if they want to provide daily leverage. A very simple way to illustrate that is, let's say, I have $100 and I want to provide one times inverse exposure. So I got to sell $100 of risk. Now, let's say that the underlying goes up and I now have $150 of risk and only $50 of cash left. Well, that's a problem because now I'm three times levered, right? So what do I have to do? I got to buy back

$100 of risk, so now I have $50 of cash and $50 of risk, right? So long story short, these products had to buy VIX features on days when VIX features were up and sell VIX features on days when VIX features were down, right? So in other words, they were trading in the same direction of the market. And I think what's really key to understanding this whole episode is that these products eventually got too large relative to the underlying market. In other words, shorting volatility was such a successful trade that these products had grown tremendously going into the beginning of 2018.

You know, I do these calculations of how big the rebalance would have to be. and by the beginning of 2018, the rebounds was about two or three times as large as it had been in 2015. And we estimated that, you know, should a shock similar to, you know, what we saw back in August of 2015 happen, there would be a lot more of VIX futures to buy and close. So this is a key thing to understand because, as you said, we've had volatility blowups from time to time in recent years. The XIV has been around several years. But it survived those other periods in part because it wasn't big enough to really impact the underlying market. Exactly.

So say like 2015 or August 2015 was a pretty big shock from markets, right? I think S&P was down some like 10%. The VIX got to 40 plus. I mean, the Brexit was a pretty big, you know, one-day shock. But the XIV and, you know, it's causing S. VIX, you survived these shocks because they weren't quite large enough to destabilize markets. And I think that's the key thing. If these products were small, then this might not have happened. But essentially, I think these products were just victims of their own success.

They got so large that the amount they had to trade was the amount of liquidity they demanded going to the close was too big relative to what the market could provide. It's kind of like a miniature version of what happened in Black Monday, 1987 with portfolio insurance, where they had to sell S&P futures as the market sold off and sell more as the market can you sell off. So they got kind of stuck in this, you know, feedback loop essentially of, okay, I had to buy VIX features. Now I've pushed VIX features up. That means I have to buy more, which means in turn that I got to buy more VIX features, right? It's this kind of feedback loop that these products got sucked into. So Credit Suisse decides to exercise basically a liquidation, right, that it has over this ETF. That annoyed quite a few investors, but it also didn't necessarily surprise.

a lot of people who had been watching this event unfold. Why was that? So earlier, we touched on the risk of inverse products and how if the underlying more than doubled in a single day, these products would effectively get wiped out, right? So what happens if the underlying more than doubles on a single day? Well, obviously, the ETF holder doesn't end up in debt, right? They only lose all their money, but the person who runs the ETF could be at risk. A person who runs the ETF could essentially lose money on this.

So if you read the prospectus of XIV, they had what was known as an early acceleration clause, which stated that if the underlying VIX features were up more than 80% in a single day, they could effectually do what's called an acceleration or they could liquidate the product and, in essence, protecting themselves and return whatever was left over after the liquidation to the holders. I'm curious about the future of this trade because it's interesting. So the SVXY, the S-Fixie, it still exists in theory if the volatility regime gets more placid again and continues to go down. It could be a very profitable trade still to buy into it. But now that we've seen this event and we've seen the ramifications of when these funds get very large and the rebalance of the rebalance of the. them starts to influence the underlying market itself. Is this just permanently a ticking time bomb where once it gets to X threshold, the risk of a blowup like this becomes significantly heightened? I think it's something to look out for it. And you know, S. Vixie did manage to survive this

episode. And, you know, if you look at fund flows, I think something like half a billion has actually entered S Vexexie since the blowup. So people are still clearly still very keen on shorting involved. Yeah, it's a risk. I mean, I will say that the, you know, the potential rebalance and the amount that that could destabilize markets is now much, much smaller, right? So the XIVC is kind of a shadow of its former self. And there are other leverage products out there tied to the VIX that, you know, it's something to watch out for, but it's definitely much less of a risk than it was before. You can get the news whenever you want it with Bloomberg News Now. I'm Amy Morris.

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And Provatt, you've said in your research that it seemed like the SVXY couldn't buy enough futures. And in the end, that kind of meant, I guess, that it was less leveraged than it should have been. And that's sort of the thing that seemed to save it. So I'm going to kind of sidetrack for a moment and just talk about how crazy things got between 4 and 415 and how much uncertainty there was about what these products were worth, if anything, right? So, you know, as I mentioned, going to the 4 p.m. close, stocked her down some like 4%. VIX features were up a decent amount. And then from 4 to 415, the blowup happened, right?

So, you know, I'm sitting there at 415. I'm looking at VIX features, and they're up nearly 100%. And, again, it happens so fast that I thought, well, maybe there's something wrong with my Bloomberg. And then it hit me like, wow. There would never be something. The first thing you can always rule out, by the way, is that there would be something wrong with your Bloomberg. Of course. But then it hit me that.

Thank you. But then it hit me that the XIV must have blown up. And I was like, I can't believe it. Like this is something that we've been calling for for, you know, probably years. And I'm looking at the XIV trading postmarket. And I'm like, wait, the XIV should be basically zero right now, but the XIV is still trading at like $90. That, you know, that's VIX. He's still trading up there as well.

I was like, wait, what is going on? Like, so either the VIX features are wrong or the XIV is trading way over fair value. So, you know, we did the math. It's a very simple math, right? You look at what the nav was last night. You look at how much of the futures moved. And we came to the conclusion, there's no way these products are worth more than call it $4. And these things are still trading at $90.

And the other interesting thing is that these products were plenty liquid post-market, right? So we had, you know, I basically, instant Bloomberg messaged all my clients and said, these products are trading way over fair value. There is no way that these things are worth anything more than four or five. bucks. And we had a lot of clients who basically went in and started shorting these products. And I was amazed that they were able to short so much. I was amazed that there was anyone on the other side willing to buy these things for, you know, paying, you know, hundreds of percent premium to fair value. So at the time, I thought, oh, it just must be like robot, you know, it's a kind of robot

market maker who doesn't know any better. You know, it wasn't until a few days later that I actually read a Bloomberg article saying that there were people who tried to buy XV postmarket because they They were so conditioned to just buy XIV and try to short VAL every time VAL blew up. And I guess the kind of funny thing is, is they were right. I mean, VIX features did go down. That appeared to be the peak for VIX futures. But obviously, they didn't make any money because they were buying this thing for way over NAV. But it just amazed me.

From 4 p.m. to 8 p.m. For four hours, these things just continued to trade a gigantic premium. And, you know, even going to 8 p.m, no idea knew what S-Victi was worth. So, you know, I called the pro shares the people who run S-Vixie and ask them, so what is the net ask of all of your thing? Like, what is it worth? And they actually couldn't tell me what, or maybe not they couldn't, but they didn't want to tell me what their fun was worth, and, you know, until the very next day.

That must have felt pretty good, A, identifying that, B, getting the message to all the people you work with who then made a bunch of money. And C, I don't know, this part feels good, but, you know, goes back to the Reddit traders and all the people online and stuff like that. And I guess that's sort of from time to time, these people who just conditions like, oh, yeah, I'm going to be the hero and buy the dip of this thing

because it always goes back up. Eventually, that just doesn't work. Well, absolutely. I mean, the funny thing is it just really depends how you did it, right? So if you had sold VIX features, actually, you would have made money, right? The problem was that for whatever reason,

the link between the ETF and its underlying value just completely broke down between 4 and 415 when everything blew up. I mean, honestly, I think the underlying moved so fast that people just couldn't do the arbitrage. The people who did step in were, you know, our clients and other people who realized that this thing was trading way ever dab and decide to short the hell out of it. But to get back to your question about why the S. Vixie survived, well, first of all, the features didn't actually go up more than 100%.

They were, technically, they were up 96%. So they survived, you know, by hair. But I think the really interesting thing was that so when the pro-share's guys, the people who run S-Fixie finally did publish a NAV, they published a NAV saying their fund was worth $4, which is what everyone thought it should be worth if you did the math. So the next day, S-Fixie opened trading at $11. And we're all wondering, why is this thing trading away from NAV again? It turns out, at least from Togne, the pro-shares, that they may not have covered as many

VIX features that they should have. So remember, I was talking about the rebound. and saying that, okay, these products have to buy VIX features when they're up and sell when they're down. So the most VIX features they would have to buy back is all of them, right? If the underlying is up 100%, well, then you cover all your VIX features and you're done. Now you have zero risk and zero dollars, right? But it seems like the S-Vixie guys just didn't cover all of their VIX features risk. So from 415, they were essentially super, super levered.

And because right after 415 VIX features collapsed, they managed to, I guess, make some money back. So they were only down 90% instead of 96%. So a lot of irony there that the product that basically operated as advertised, the XIV collapsed and the product that didn't necessarily operate as advertised, the asphyxie survived. As we sift through the rubble of the volpocalypse, there's a big question that a lot of people were asking, which is, of course, did the tail wag the dog? So did all these VIX related products end up impacting the VIX index via VIX futures, and then did that end up impacting the wider market? I'd love to get your thoughts on that.

So I think the VIX products did affect VIX futures. In other words, I think the action of XIV and S VIX and all these other products covering short VIX features, going in the close, that definitely affected VIX features. They pushed the market against themselves and effectively self-destructed, right? I mean, it's sort of like a miniature version of what happened to long-term capital management. Okay, they were too leverage. They tried to cover their risk and they ended up pushing the market against themselves. Do I think that move the VIX spot? Yeah, I do, because if you're buying VIX features, ultimately that ties back into you buying VAL and essentially, yeah, you push the price of VAL up. So I think it moved the VIX spot. Do I think it move the S&P? That's a more difficult question.

right because I think you know there is kind of a a link between all the risks in the world right we know that okay if S&P is down then probably you know the yen is gonna be bid and Treasury is gonna be bid and VIX features gonna be bid and so there's kind of a kind of a need jerk link between all these things so if Vix features are up you know a lot after the close I have to think that yeah in some way S&P futures are gonna be down and they were down after the close on that day so I think yeah you know it may have contributed the extra or two, we saw S&P Feature Sell Off post-market.

Providence, we could probably talk about this for hours, and I think we should reschedule the next one, because as you say, people are already piling back into this trade. So I doubt we've seen the last turn of the screw on this story. But thank you so much for this. It's one of the most fascinating, interesting conversations we've had in a long time. Thanks for having me. Appreciate it. So, Joe, can I just say one thing? Yeah. That felt so good. Yes. It felt so good to do a deeply wonky markets podcast about something that's actually happening in the market. It made me so happy. That might be, in all honesty, like the sort of, that's what we should go for every time,

like that level of conversation where it's timely and it's on the market. And I think we really helped demystify something. I certainly learned a lot. I mean, we covered this intensely during that week, but this still really helped me understand what exactly it was that we were covering. Yeah, and I suspect there's going to be a lot of this that we can cover going forward, because there are still some major questions surrounding these products. A big one is, is there going to be a regulatory backlash against the VIX index itself

and the company that provides it, the CBOE? And secondly, is there going to be a regulatory backlash against people who were providing these specific products? You know, the XIV was pretty clear saying that it was only, supposed to be used by sophisticated investors, but you and I both know that there was a ton of retail money in it. So was that the fault of the issuer? Was that the fault of the regulators? Was that the faults of brokerages that were allowing retail investors access to these products? There are so many questions people are going to be talking about.

Absolutely. And Tracy, I just want to say of all the, you know, I knocked at the beginning financial journalists and I said nothing that financial journalists predict actually happens. And that's mostly true. But you're an exception. You've been writing about these issues for a long time. And I think you deserve a lot of credit for talking about the relationship between these products and how they, as you put it, the tail could wag the dog at the end. So props to you. Well, you can't see me because I'm in Abu Dhabi, but I'm blushing.

That's very sweet. Thank you, Joe. On that happy note, this has been another edition of Oddlots. I'm Tracy Alloway. You can follow me on Twitter at Tracy Alloway. And I'm Joe Wisenthall. You can follow me on Twitter at the stalwart. And you can follow Provitt on Twitter at Provatt underscore C.

And you should follow our producer, Tofor Forges, on Twitter at Forthes underscore T, as well as the Bloomberg head of podcast, Francesca Levy, at Francesca today. Thanks for listening. On April 4, 23, around 2 in the morning, a man was found stabbed multiple times on a sidewalk in downtown San Francisco. Hey, who did this to you? What happened next turned the story into a political firestorm.

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