Introduction

The volatility markets have already experienced two seismic events in 2018. First the sharp devaluation of inverse VIX Exchange Traded Products (ETPs) on February 5th leading to the retirement of the Credit Suisse issued VelocityShares Daily Inverse VIX Short-Term ETN (XIV) and the lesser known Tokyo listed Nomura Next Notes S&P 500 VIX Short-Term Futures Inverse Daily Excess Return Index ETN (2049: JP), and then the deleveraging of the popular ProShares Short VIX Short-Term Futures ETF (SVXY) and Ultra VIX Short-Term Futures ETF (UVXY) on February 27th. How did this happen, should we have seen it coming, and what if anything could have been done to avoid it?

The Internet is unfortunately awash with opinions and misinformation. We hope this article will help clarify a few facts and put an end to some of the more absurd speculation. If you haven’t already read my article from August 2017 entitled ‘VIX ETPs: A Crowded Trade?’ I highly recommend you do first. In that article, I lay out in simple terms the mechanism by which VIX ETPs are linked to the S&P 500 (SPX) volatility market, how this link ties into the broader SPX cash market, and how this pointed to a crowding of the inverse VIX ETP trade. Since February 5th that article has received thousands of views and has been the topic of several financial news articles and online discussions.

Over the last 20 years, I have written extensively about the history of volatility trading and the meteoric growth of Assets Under Management (AUM) in inverse VIX products and their popularity with retail investors, and I have made a career out of managing volatility exposure for institutions, high net worth individuals, and more recently, sophisticated retail clients. Perhaps the most notable take away from this experience has been the shift in volatility trading from the centralized trading floors of large investment banks to the far more decentralized retail accounts in the last five or so years. This shift changed the way volatility markets work, and more importantly, created new risks that, until now, have been poorly described.

The idea of introducing an exchange-traded volatility product was first discussed in the US in the early 2000s. At the time the thinking was that fund managers would be attracted to a long volatility product that would allow them to make efficient short-term portfolio hedges using a liquid product that traded like a stock on a major stock exchange. This was the genesis of the Barclays Bank PLC iPath S&P 500 VIX Short-Term Futures ETN (VXX) launched in 2009 and if you’d like to read more about the history of this product and other volatility products in the US I recommend my article ‘The VIX and a Brief History of Volatility Trading’. As that article points out, there was little expectation at the time that retail investors would take much interest in the product, and this was indeed the case at least in its early years.

However, things quickly changed and more recently a great deal of the interest in VIX ETPs has come directly from retail investors looking to take short volatility positions either by shorting the VXX and/or by buying one of the popular inverse VIX ETPs like XIV and SVXY. With hindsight the popularity of this trade is understandable. Until January 2018, the inverse VIX ETPs had delivered astonishing returns putting short VIX products on the radars of even casual stock traders.

All this changed on February 5, 2018. After a 4.1% correction in the SPX, and, in what looked like a flurry of after-hours trading, the XIV lost more than 96% of its previous day’s value, and the SVXY followed suit with a similar, although slightly smaller, decline. So why did a relatively mild correction in the SPX cause these products to lose so much value so quickly? The answer lies in two related but separate facets of the VIX ETP market: the size and popularity of the short VIX ETP trade, and the mismatch between VIX futures risk and SPX options risk. Let me explain.