BlackRock warns of risk as inverse volatility products sink

BlackRock warns of risk as inverse volatility products sink

A popular Wall Street instrument used to bet against market volatility has blown up in investors' faces.

And while high-frequency trading does often exacerbate volatile markets, Themis Trading's Arnuk said this week's turmoil didn't begin there.

"This buying pushes the volatility higher still, reducing AUM further, and making the issuer's hedging portfolio notionally more short, inducing further VIX futures buying to resize the portfolio to shrinking AUM", Weisberger said.

Derivatives contracts tied to the VIX - known as the "stock market's fear gauge" - have grown rapidly in recent years as central bank stimulus and a recovering global economy lowered volatility across asset classes.

The product was devised in order to benefit from the calming impact on the stock markets of initiatives such as quantitative easing.

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Once the investor has calculated risk and decided on a suitable time horizon, they may be wondering how to best start doing research on particular stocks and the market in general.

Credit Suisse's VelocityShares Exchange-Traded Note (XIV) lost more than 80pc of its value following Monday's sell-off.

Last year, traders argued that the VIX remained depressed because realized volatility in USA equities has diminished and economic fundamentals remain supportive.

Because the products bet on market volatility remaining low, or declining consistently, they essentially profit from the difference between the price of volatility now and in one month's time.

Dave Roberts, an independent trader of volatility products and associated derivatives, noted that at the expiry of the January VIX contract, the front and second-month contracts were trading at a fairly narrow spread, in contrast to the wider gap at the December expiry. "Nevertheless, the Swiss lender this morning set a redemption date of February 20, for the volatility note, well ahead of the December 4, 2030, maturity date", according to Schaeffer's Investment Research. As of the date hereof, Credit Suisse will no longer issue new units of XIV ETNs.

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XIV had a net asset value of $4.22 on Monday, down from $115.55 on Friday.

Credit Suisse, which is the biggest holder in one of the products, is down more than 6% in after-market trading.

Investors said the proliferation of short-term traders, some using computers to trigger trading decisions, had also exacerbated the price swings of the past few days. So let's assume the next day the VIX rises back up to 10.

The repercussions have been severe for some funds.

"If the price of the underlying futures contracts increases by more than 80 percent in a day, it is extremely likely that the Inverse ETNs will depreciate to an Intraday Indicative Value or Closing Indicative Value equal to or less than 20 percent of the prior day's Closing Indicative Value and will be subject to acceleration", according to a prospectus. Along with that, you may have head reference to volatility products like "the VIX", and an ETF called VelocityShares Daily Inverse VIX Short-Term ETN (NYSE:XIV) having a "liquidation event".

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A similar fund run by Nomura Securities is being liquidated after it crashed. So when volatility spiked by a record 116% on Monday, the funds plummeted.

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