If you’re anything like me, you might have been surprised at the 4% drop in the S&P 500 (SPY) and the DJIA today when you got home from work. However, that is nothing compared to the massive volatility spike that occurred in the CBOE VIX index. The VIX index is a formula based index that calculates the underlying volatility in the S&P 500, as exhibited by S&P 500 options. Forgive me, I realize that’s very technical, but this post will be full of technical details. These details are vital to understanding what has happened today. Basically, Short Volatility ETNs or Short Vol ETNs such as XIV have reached a liquidation event. ETNs are similar to ETFs but instead, are structured more as debt versus equity.

As far as I can tell, no official liquidation has been announced, but it’s relatively easy to use the publicly available information to determine that a liquidation event or equivalent has occurred.

The result is bad. Very Very Bad.

Primarily for anyone who owned one of these products such as XIV, SVXY, VMIN, EXIV, IVOP, XXV, and ZIV.

However, these negative effects can have cascading consequences which might affect the price of the entire stock market.

A basic primer on the Short Volatility Trade

In order to really understand what today’s Short Volatility liquidation means for markets, you need to understand how the Short Volatility trade works.

Let’s start simple: If you’re long volatility then you make money when the VIX index or the volatility index goes up. The opposite happens if you’re short volatility. When you’re short volatility, you make money when the VIX index goes down, and you lose money when the VIX index goes up. That makes some sense.

VIX Futures Contracts

However, you can’t actually buy the CBOE VIX index. It’s just a number which is calculated constantly by a formula and published online. In order to go long or short volatility, you used to have to buy and sell volatility futures. This future market arose to allow speculators to make calculated bets on the outcome. These speculators were typically hedge funds and pension funds. Otherwise experienced investors who know what risks they are taking.

Futures contracts allow these ‘sophisticated investors’ to bet what price the VIX will be on a specific day and at a specific time. These “closing days” take place once a month.

It turns out that trading in these futures contracts was extremely profitable over the last eight years as volatility has consistently gone down. Specifically, it has been extremely profitable for those shorting volatility in the future market. They’ve been able to cash in on lower volatility in almost every month during this time frame.

The creation of retail short volatility products

However, this large profitability led to ETFs and ETNs being created to allow retail and less sophisticated investors to join in on the money making. This is where the Short Vol ETN the XIV comes into play. (Note: I’m using XIV as an example here. Each of the short volatility products can show similar relationships over the last decade.)

The XIV ETN began trading at the beginning of December 2010 at approximately $11.04 per share. Between December 3rd, 2010 and January 12th, 2018 the price of XIV had risen by $133.71 to $144.75. This represents a 1,211% gain in eight years. (Note: Data were taken from Google Finance). Essentially an investor multiplied their money by 11x in that time frame. That’s an insane return. When you look at those returns, it’s hard not to be tempted to buy in at any point in those last eight years.

Short Volatility Retail Products profit from positive carry on futures rollover

One of the key reasons for this large return is that XIV makes money in a way that traders of the volatility futures do not. As I said earlier, futures only settle or close on a single day each month. However, the retail products trade daily and rebalance on a daily basis. They usually rebalance by changing the proportion of first month and second-month futures. During a normal market, the predicted volatility of the first-month future contract is lower than the predicted volatility of the second-month contract. This means that every day, long volatility products have to pay additional money to maintain their long position.

On the other hand, short volatility products earn money every day by maintaining their position. This is essentially an insurance premium payment made by long volatility traders to short volatility traders.

This insurance function is absolutely key to how today’s liquidation event occurred.

What Happened? How did XIV reach a Liquidation Event?

Yesterday, the CBOE VIX index closed at a value of 17.31 after two days of relatively high volatility in the market. For reference, the stock market has had volatility near 10 for the past year as the S&P 500 and DJIA have crept steadily higher in price.

When the VIX index closed today it had risen by 115.60% to close at a value of 37.32. This rise of over 100% is where short volatility traders lose everything.

Basically, if a VIX gain of 100% means that long volatility traders gain 100% on the day. The opposite means that short volatility traders have a (-100%) return for the day. A complete loss.

The mechanics of a liquidation event for Short Volatility Funds

Although above I refer to a complete 100% loss, that’s not actually what will generally happen. The issuer of the short volatility fund, in the case of XIV, this is Credit Suisse (CS), will attempt to reduce short exposure before a 100% loss is actually reached. For XIV, Credit Suisse has determined that an 80% loss in a single day is the point at which they will likely (although not definitely) begin to forcibly liquidate the fund.

The source for this is the Prospectus of the Fund itself. For clarity, the prospectus calls what I’m talking about an “Acceleration Event” instead of a Liquidation Event. They’re basically the same thing though. The below image is a snippet directly from the Prospectus.

Therefore, if Credit Suisse has chosen to liquidate the XIV short volatility fund, all owners of the fund are going to be forced out at a pre-determined price. Although an official announcement has not yet occurred, let’s examine if this has happened.

XIV is highly likely to have triggered an Acceleration Event / Liquidation Event today

Based on data provided by Velocity Shares ETNs, XIV closed on Friday at $115.55. During market trading today, the price closed at $99.00. However, immediately after the close, prices of XIV began to plummet and currently trade at $15.43. This represents of over 86% in a single day.

However, that doesn’t tell the full story. Market price is not the important factor. Instead, the important piece is the “Intraday Indicative Value.” As we see in the image below, XIV ended trading today, February 5th, 2018 with a closing Indicative Value of $4.22. Although I lack data on the closing indicative value from Friday, we can assume it is fairly close to $115. Based upon that, we see that the indicative value has a loss of approximately 97%. ($4.22/$115)

Negative Fallout: Cascading wave of selling which could lead to a Stock Market Crash

The result of all of this is likely a stock market crash. Let’s walk through the process. There are two parts: retail and institutional.

The retail effect is fairly straightforward:

First, XIV shareholders are liquidated. Either at or near Net Asset Value which represents an 80-100% loss. Second, margin calls affecting some XIV holders will force them to sell any and all assets, including stocks, to raise cash to meet their margin calls. This will promote initial selling pressure. Third, large selling pressure across the board will make many investors cautious to buy into an ongoing crash, reducing bid liquidity. Fourth, an initial decline triggers stop-loss trading strategies to sell at a loss removing further liquidity from the market. Finally, the ongoing decline causes an even larger rise in volatility, and hedge funds, pension funds, and corporations with secondary exposure to short volatility become impacted. The cycle then repeats.

The Institutional Impact of Short Volatility Risk Covering

Institutional effects are a lot more complicated, but they might also have the greatest impact. Remember that all of these short volatility funds are actually trading in the volatility futures market. At first, it might seem like the futures market is completely independent of the stock market itself. However, that would be a mistaken assumption. Trading in the futures market has an indirect but critical impact on the stock market itself.

While the volatility index is unable to be traded directly, this is not true for the stock market index. The stock market index can be traded in four different ways.

Buy the stock market index itself such as the SPY ETF. Purchase each individual stock in the stock market index. Buy options on the stock market or individual stocks. Trade stock market futures that settle against SPY.

Institutional investors such as Hedge Funds, Pension Funds, and Corporations can Arbitrage differences in ETFs, Options, and the underlying stocks

Remember that at the end of the day, buying through any of these four methods still results in essentially buying ownership of the underlying companies. Yet, the ability to buy those companies in different ways allows large institutional investors to arbitrage differences in the prices allocated within any of the four avenues against each of the others.

Basically, if S&P 500 trades at $2600 while the S&P 500 futures contract trades at $2700, an institutional investor can buy the S&P 500 index (SPY) while selling the S&P 500 future and pocket the difference of $100 as profit.

This relationship works great most of the time. However, in a black swan style event such as the forced liquidation of XIV, this can have devastating consequences.

XIV Liquidation is a Black Swan event for the Stock Market

Let’s discuss the institutional fallout of XIV’s liquidation.

The XIV fund along with its fellow short volatility funds like SVXY were *Short* volatility futures. I know this is a given, but it’s important. Because XIV was short the futures, they were forced to buy back a huge number of futures contracts after the stock market closed in order to cover their short position. According to Pravit_C on Twitter courtesy of Robin Wigglesworth, XIV and SVXY had to purchase approximately 200,000 VIX futures contracts.

That is the definition of a short squeeze.

Unfortunately, that means other people sold 200,000 VIX futures contracts in that time frame. Those futures contracts are the spark that lights the fire of my cascading effect proposal.

The Futures market can lead to massive selling pressure in the Stock Market

In order to arbitrage away the risk of those 200,000 VIX futures contracts, the sellers will need to sell options against the SPY or other S&P 500 index proxies. Alternatively, they can sell stocks in the S&P 500 directly. In fact, they can use any of the three other methods mentioned above, in order to reduce their risk. They’ll likely use all three.

What all of this means is a massive flood of selling pressure will likely begin in the stock futures market before the market opens tomorrow morning. This futures selling will then lead to actual stock selling at the open, leading to a massive stock market crash.

This forced liquidation of XIV could then function very similarly to the portfolio insurance phenomenon that caused the -22% single-day drop in October 1987 on Black Monday. Forced selling will feed more forced selling, and the sheer volume of sell orders can overwhelm the available buying liquidity.

Conclusion: XIV Short Volatility Liquidation creates a Margin Call which cascades to both retail and institutional investors selling in strength causing a Stock Market Crash

This may sound dire, and it is. Yet, I can’t guarantee that this will actually happen. I only know it’s a possibility and one that should be prepared for.

The initial shock has already occurred. Now we just have to deal with the after effects. The forced liquidation of XIV, whether actually realized as an acceleration event or not doesn’t matter. The massive short covering by XIV and SVXY has already baked a large futures impact into the cake. We’re going to have to deal with it in the coming days, weeks, and months.

This should be an important reminder about the importance that risk management should take in your investments at all times. Always include risk mitigation as your first goal, so that you can avoid being impacted by black swan events like this.

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