Schaeffer's Trading Floor Blog

The Rise and Fall of VIX-Related Trading

Charting the epic collapse of the TVIX

by 6/13/2014 7:58 AM
Stocks quoted in this article:

The only thing we have to Fear is Lack of Fear Itself!

That's not true in the market, as we (and others around the street) have shown recently. A low CBOE Volatility Index (VIX) does a better job of reflecting a trend well in progress than predicting when that trend will end.

It is true if you're actually trading a VIX-related product. And then some. We usually highlight the iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA:VXX) as the definition of a challenged ETN, but it's not the worst of the worst. You could use VelocityShares Daily 2x VIX Short-Term ETN (TVIX) instead, which combines all the wonders of VXX, and then leverages it up 2x and packages it in ETN form.

Anyways, The Wall Street Journal took up the subject this week.

The latest big worry to hit markets is an unusual one: calm. With stock prices high and various gauges of risk low, investors appear to have thrown caution to the wind.

That isn't entirely true, though. Exchange-traded notes that profit handsomely from market-shaking events have boomed since the financial crisis. But they have two big shortcomings: They may not work as designed in another financial crisis since their value depends on the bank backing them. And due to the way the products work, anyone holding these for the long term will inevitably see their value erode.

...One popular product with the catchy name of the VelocityShares Daily 2x VIX Short-Term ETN is designed to produce double the daily return of short-term VIX futures. Had it been around in September 2008, it would have surged by over 1,000% during the next three months. Or it could have gone to zero. That is because the notes are dependent on the firm sponsoring them. The VIX is just a calculation based on the prices of options for the S&P 500 index. So unlike oil futures, contracts tracking the VIX aren't backed by anything besides the promise of a bank to pay the return on the index.

He really hits all the highlights in just a few paragraphs. Yes, these products would have soared in 2008. In fact, that's the main reason why they exist today. In 2008, everyone wanted more ways to own volatility. The problem is that financial crises are fortunately the exception and not the rule.

All tracking ETNs compound the daily results of the underlying. Hence the strong downtrend in the market in 2008 begat a strong uptrend in volatility, which would have produced the monster returns. But alas, at pretty much all other times since March 2009, volatility has either drifted or flatlined. And neither helps these trackers. It's a "death by 1,000 cuts," as he mentions.

TVIX -- and the ProShares Trust Ultra VIX Short-Term Futures ETF (UVXY) -- make the whole matter worse by leveraging it up. It's double the misery.

And finally, TVIX takes the cake via its Exchange Traded Note structure as it adds a layer of counter-party risk. Back in 2012, Credit Suisse briefly stopped creating new TVIX shares. The market, for whatever reason, started pricing TVIX at a significant premium to net asset value. The shares were unborrowable, and with no arb mechanism readily available to push them in line, they stayed at a premium. That is, until Credit Suisse started creating shares again about two weeks later, at which point TVIX crashed and some unwitting owners got slammed.

Fun Times!

But here we are. As the chart in the Journal shows, TVIX was as high as a split-adjusted price of $10,000 as recently as the end of 2011. It's now at $3.50.

If you stay away from VXX religiously, you should avoid TVIX exponentially more. Well, avoid holding it for anything more than a day or two. If you catch a volatility move, great. But time is literally money, and TVIX makes the decay on regular options look like a rounding error.

Disclaimer: Mr. Warner's opinions expressed above do not necessarily represent the views of Schaeffer's Investment Research.


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