How Shorting the VIX Blew Up the Market, and Why It Could Again

If you didn't know what the Chicago Board Options Exchange Volatility Index (VIX) is, you almost certainly do now after the correction.

Plenty of regular investors don't realize how the VIX works, though - what makes it move up, down, and sideways.

You can't trade the VIX directly - it's a mathematical calculation, after all. But a whole buffet of easy-to-trade, not-so-easy-to-understand exchange-traded products (ETPs) make it possible for anyone - mom-and-pop retail investors, institutional traders, risk parity funds, and newly minted hedge funds - to bet on the VIX moving up, down, and sideways.

These folks saw the VIX doing a whole lot of nothing for more than a year and bet accordingly, to the tune of tens of billions of dollars.

And for a time... it was good (notice I didn't say "smart").

But earlier this month, when human and silicon investors and traders got spooked, the VIX spiked - spiked like never before, in fact - jamming an ugly, red-hot poker into that great big, happy, feel-good short volatility bubble.

All the investors and traders out there who spent a year or more picking up pennies in front of a double-decker bus got killed when their favorite ETPs blew up.

What happened after that... well, we're still dealing with it and could be for some time. The market's trying for a run higher from here. It's already pared about half its losses from the depths of the correction, but the road isn't as smooth as it was just four weeks ago.

Amazingly, the trade that started this whole mess is still out there. Sure, a few high-profile short volatility vehicles imploded, but it's still very possible for this to happen all over again.

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VIX Trade Is on Main Street to Stay - Get to Know It

When I helped create the VIX decades ago, it was just another one of many tools the professional traders used. It would've been unusual for a regular investor to even know what it was, let alone bet on it with futures or leveraged derivatives.

Today, the VIX has become so popular, it's like its own asset class: There are ETPs and inverse ETPs that track it, and options and futures, too.

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So it's now essential for every investor to understand how it works, and what it does and does not do.

In its most basic form, the VIX is an index. It's an index of "implied volatility," which is a mathematical calculation of expected volatility (how much something will move up or down) that investors price into options they buy and sell.

Historical volatility - how volatile something has been over time - is part of the Black-Scholes options pricing model, used to calculate the theoretical value of an option.

Implied volatility (which is also a number) is extracted from a re-worked Black-Scholes formula that looks at the actual price investors pay for options, as opposed to theoretical value. The assumption is that real-world options prices have real-world volatility expectations baked in, implied by what investors actually pay for options.

The VIX takes options that investors buy and sell on the S&P 500 (a proxy for the market) and extracts all the implied volatility numbers in each of the options, weights those implied volatility numbers, and comes up with an index of the implied volatility of the market, as measured by the S&P 500.

If the VIX is at 10, it means investors are pricing in a possible 10% move in the market over the next 30 days. If the VIX is at 50, it's priced in a possible 50% market move.

That's scary, and that's why the VIX is called the "Fear Gauge."

Now, about those bets...

Here Are All the Different, Popular Ways to Play the VIX

With equity markets rising steadily for years, the VIX has been remarkably subdued. It spiked a few times over the past five years on negative news, but always managed to calm down quickly, and for the most part, it has been trading at low levels, around 10 to 15, for long... long... long periods of time.

If investors want to bet the VIX is going to rise, they can buy futures or ETPs that track the VIX and pop higher when the VIX does, or they can buy call options on the VIX itself.

They can bet the VIX will fall by shorting futures, by buying inverse ETPs right before they expect a fall, or by buying put options on the VIX.

Besides bets on the VIX going up and down, investors figured out that a couple of inverse ETPs that are constructed to go up in price when the VIX goes down keep going up even if the VIX does nothing.

Those two ETPs are the soon-to-be defunct VelocityShares Daily Inverse VIX ETN (Nasdaq: XIV) and the ProShares Short VIX Short-Term Futures ETF (NYSE Arca: SVXY).

The reason they keep going up in price when the VIX is going sideways is because they are based on futures contracts.

ETPs constructed to go up when the VIX goes up also uses futures to track the VIX.

The nature of most futures prices is that they are more expensive the further out to expiration they are. That's because owning futures gives you the right to buy the underlying commodity or index in the future and not have to pay to have it delivered now, or must pay to store it, or finance its purchase.

The further out the futures go, the more time you're buying. Sellers of futures know that, and they charge buyers for that time. That's why near-month futures are cheaper.

When sponsors of VIX ETPs who try and track the actual VIX use futures, they buy near-month futures because they are the cheapest, and when they get close to expiring, they sell them and buy further-out-month contracts, which are more expensive.

Buying near-term futures and selling them and buying further-out futures is called "rolling."

The problem with ETPs that try and track the VIX with futures is the roll. Every time futures must be rolled forward, it costs the fund more and more and more. That's why ETPs that are supposed to track the VIX when it goes up keep losing value.

Here's the "ah-ha" moment.

The Short Volatility Trade Is Still There to Blow Up Again

You see, those ETPs that are constructed to be inverse, which is to say, to go up when the VIX goes down, work in the exact opposite way.

Because they are tracking the inverse of what "long" VIX funds do, they benefit by the roll because they're tracking a negative roll. So they keep going up in price even if the VIX is doing nothing.

It's a no-brainer. A lot of investors played a sideways-trending VIX by buying inverse VIX ETPs XIV and SVXY. They kept going up...

Market Correction

...until volatility spiked in early February, and they crashed.

XIV crashed more than 87%, and SVXY fell close to that.

What all those investors sitting on accumulated profits - which a lot of them kept ploughing back into the same trade - didn't think would happen happened - big time.

One lesson I've learned in my decades in the markets: Volatility always happens. It's a fact of life; it's how the markets roll, so to speak.

What's worse, XIV is an exchange-traded note. It's an ETP that happens to be a note, which is a debt instrument. That's how Credit Suisse, the sponsor, creator, and manager of XIV constructed it - as a debt obligation it promised to make good on until it didn't want to.

Credit Suisse didn't want to sponsor it any more when it crashed. What investors didn't read in the fine print of the XIV prospectus is that Credit Suisse could terminate its notes if a crash like what happened happened.

That left investors with all their losses and no way to stick it out and see if XIV could rise again.

So much for betting on volatility doing nothing and watching your profits accumulate for however long.

The key takeaways: There's no free lunch on Wall Street, and sometimes, those pennies you find on the ground in front of double-decker buses aren't worth picking up.

SVXY is still alive. Its sponsor is letting it trade. So, if you want in on the game, you can still play. It's still out there waiting for investors with short memories to hop back aboard.

Just be careful not to roll all your profits into the future; it isn't always that bright, or calm.

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About the Author

Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.

The work he did laid the foundation for what would later become the VIX - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.

Shah founded a second hedge fund in 1999, which he ran until 2003.

Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.

Today, as editor of Hyperdrive Portfolio, Shah presents his legion of subscribers with massive profit opportunities that result from paradigm shifts in the way we work, play, and live.

Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on Fox Business's Varney & Co.

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