Just because a stock has been running hot doesn't mean it will continue to go higher in the future.
But those bets suddenly went bad this week when the market took a terrifying plunge.
That's a tiny fraction of the roughly $2 trillion estimated to be linked to short-volatility strategies - and a speck of dust compared to the $23 trillion in market value of S&P 500 companies. Analysts at Goldman Sachs Group Inc., agreed, noting that the volatility complex was effectively long vol after Monday's big move. "And it blew up in their faces".
"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.
But as the VIX index soared this week, more than doubling from Monday's closing price to Tuesday's open, inverse VIX funds crashed.
The product was devised in order to benefit from the calming impact on the stock markets of initiatives such as quantitative easing. Its sponsor, Credit Suisse, says it will fold up the ETN, liquidate it, and make a cash payment to its owners, locking in losses for those who hold it.
The bank said Tuesday it will terminate the product and redeem the notes, which were worth a combined $1.6 billion on Friday.
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Watching the trading indicators on shares of VIX Mid-Term Futures ETN Ipath (VXZ), we can see that the twenty one day Wilder Moving Average is presently above the 50 day Simple Moving Average. He said it "absolutely" contributed to the market turmoil.
Monday's volatility shock in US stock markets had led to some misconceptions about the Cboe Volatility Index, known as the VIX.VIX, and related exchange-traded products (ETPs), Cboe's Tilly said.
"It spirals", Block said. Let me give you a simplified example. More than a dozen of volatility-pegged products were halted on Tuesday as the Cboe Volatility Index gyrated wildly. But those concerns may not fully explain the severity of the losses.
No one knows for sure what played out on the afternoon of February 5 on Wall Street, cautioned Societe Generale SA managing director Ramon Verastegui, but there's reason to believe the sharpness of the retreat in equities was linked to traders' understanding of how the exchange-traded products would behave. Investors may use the 200-day MA to help smooth out the data a get a clearer long-term picture.
A number of other hedge funds and other institutional investors have also recently added to or reduced their stakes in the business. The RSI is computed base on the speed and direction of a stock's price movement.
Kristina Hooper, chief global market strategist at Invesco, said there were "a lot of forces at work", but the short volatility trade blowing up "certainly aggravated it".
The good news is that unlike the risky mortgage securities at the heart of the 2008 crisis, these volatility instruments don't change the overall economic environment.