Wednesday, February 7, 2018

"The Astonishing Story Behind What Really Happened to XIV"

From Capital Markets Lab:
Date Published:
LEDE
Hello, all. This is Ophir writing.

During the market's closing hour on Monday, February 5th, some sort of "flash crash," likely triggered by margin calls, attacked the CBOE Volatility Index (INDEXCBOE:VIX), also known as the "fear index."

What was a bad day, turned into a never before seen move. Here is it:

Whatever it was, the VIX went from 17% to 37% in a matter of two-hours, or up 115%. That is the largest percentage gain in the VIX in one day ever recorded.

Even then, while that is a huge move, it wasn't really market disruptive in any great way other than, the market had a bad day. But then the after hours margin calls came in -- and that was an unmitigated disaster for one particular instrument of interest to us: Credit Suisse AG - VelocityShares Daily Inverse VIX Short Term ETN (NASDAQ:XIV).

DON'T LISTEN TO TV
The reporters on television have no understanding what XIV is -- it is not a naked short bet on VIX. No, it is an investment in the core underlying principle of market structures, driven by positive interest rates, known as Contango.

Remember, the XIV is the opposite of VXX, and the expected value of VXX is zero. Here it is, from the actual VXX prospectus:



This instrument is not a radical short trade, it is fundamentally an investment in an ETN that reverses the value of an investment that is ultimately expected to be zero, which made it so good, for so long, and would have for several more decades.

WHEN A LINE BECOMES THE FOCUS
A little detail in the prospectus of XIV is that, hypothetically, should it lose 80% of its value from the close, it would cause a "acceleration event." That means that if the XIV sunk to 20% of its value, it would go to zero and the ETN would go away (and start over later).

Now, obviously, this had never happened to XIV before, but it's only a decade old. When scientists back-tested XIV all the way back to the 1987 crash and including the 9/11 terror attacks, they noted that even then, XIV would not have suffered a 80% decline in a day. But we have never seen such a market with so many naked short vol sellers as we have today....
As a barometer, even as crazed as Monday was, here is how XIV closed:


Down 14.32% is ugly, but, it's just a day -- a bad one, but nothing really all that crazed. Then the after hours session happened, and the best anyone can tell, as of this writing, is that some firm (or fund) had to unwind a short volatility position due to a margin call.

That meant they had to buy the front month expiration of the VIX futures, leaving the second month unchanged. That little detail is everything, because the XIV is an investment on contango -- when the second month is priced higher than the first month. This is a market structure apparatus -- we could call it "normal market structure."...
...MUCH MORE

HT: FT Alphaville's Alexandra Scaggs, who I see has changed her hair for her Twitter pic.
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