The equity markets suffered further losses Monday after feeling under enormous selling pressure late last week, capitulating at one point during Friday’s session when the S&P 500 Index traded as low as 1168.09.
For most of the trading session on Friday, equities traded in the red (with the Dow closing higher after eking out a gain) and at one point, with equities trading at their lowest levels since late November of last year, we actually saw the VIX (CBOE S&P 500 Volatility Index) leap fiercely and suddenly, trading as high as $39.25. This was the highest intraday price point touched in VIX since May of 2010 (during the week of the Flash Crash).
But on Friday, this was not an isolated event, as VIX related ETFs and ETNs also traded briefly (we cannot overemphasize the word “briefly” here as it lasted not minutes but more like seconds. For further explanation, please refer to any intraday chart for the VIX or related ETFs and ETNs) at extreme levels, not only on an intraday basis, but on a recent historical basis relative to levels the markets are used to.
Some market participants and financial pundits have feared such extreme intraday moves in ETFs would resurface at some point, and resemble the “Flash Crash” of May 6, 2010, where ETFs traded at values completely unrelated to the actual “real” underlying index values (IV or NAV) of the fund’s themselves. In the past year or so, many have retold the tale of Rydex Equal Weight S&P 500 (NYSEArca: RSP) briefly trading as low as $17.73 but related S&P 500 Index based ETFs did not temporarily suffer this same fate during this same and sporadic timeframe. (In perfect hindsight, RSP, and other ETFs that temporarily traded at steep and erroneous discounts to their real index values last May, were screaming buy opportunities, and potentially year changing, or even career changing trading opportunities.)
Intraday price movements such as those of last year’s Flash Crash, however so brief, defy the way ETFs are constructed as basket related and arbitrage priced, and how they function as index based vehicles. That said, the vicious and sudden price movements in the VIX and V IX related ETFs and ETNs during the intraday lows in the S&P 500 Index itself last Friday were real. These were not based on bad price feeds, or index data temporarily not matching actual ETF bid/ask prices as in the May 6, 2010 Flash Crash, but were rather true reflections of fear of additional degradation in the S&P 500 Index (the intraday low on Friday was ultimately 1168.09, just as the VIX gapped up to $39.25 as investors were racing for “protection” in scrambling to buy instruments that would prompt such a spike in the VIX Index).
This includes S&P 500 Index puts, puts on SPDR S&P 500 (NYSEArca: SPY), and options and futures in the VIX itself. Feeding on this frenzy were actual sellers in S&P 500 futures, the underlying equities, S&P 500 related ETFs, and other “long” equity products and derivatives. Thus, despite the ferocity and suddenness of this intraday move, it was in fact “for real” and not an issue of ETF/ETNs malfunctioning due to bad price/index feeds such as the Flash Crash scenario of 2010.
Offering proof that this perhaps exaggerated VIX move was not simply an isolated event that affected one or two “VIX” products in an undue manner, please refer to the attached table which shows the context of the intraday price ranges (highs/lows/closing prices) of various VIX ETF/ETN products, both those with long and short objectives. It is important to note that whether we are speaking about iPath Short Term VIX Futures ETN (NYSEArca: VXX) or VelocityShares Inverse Short Term VIX Futures (NYSEArca: XIV), none of the VIX related ETF or ETNs on the product landscape are 1:1 correlated with the VIX itself. In other words, none of them offer perfect exposure, in lockstep, to the actual moves of the VIX index itself.
When digging into the index construction of these ETFs and ETNs, it becomes clear that none of them are designed to actually replicate returns of the spot VIX index itself, nor are they a direct investment in the VIX, but instead track an index geared on some aspect of the VIX. Will a perfectly correlated VIX ETF/ETN emerge at some point in the future? The answer is unclear, but we are fairly certain that a number of ETF issuers are researching it as we speak, but it is sometimes easier said than done to package futures related products that minimize tracking error to some designated benchmark within an ETF wrapper.
This said, investors are using the tools that they currently have on the ETF and ETN front to speculate on VIX moves, or perhaps to use VIX related instruments as potential volatility hedges in their portfolios. This is where an understanding of the individual limitations of VIX ETFs/ETNs really becomes crucial when utilizing them adeptly in portfolios. Thus, we would strongly encourage those using, and interested in using such products to closely examine the individual objectives of each VIX related ETF/ETN as well as potential tracking issues against their designated benchmarks and the VIX itself. For example: it would likely shock many portfolio managers to hear that even with the VIX itself up over 80% year to date, related “long” VIX ETNs such as VXX and VXZ have lost 19.41% and 18.49% year to date due to limitations on their methodologies and rebalancing effects within the portfolios themselves.
We asked one institutional manager who utilizes VIX related ETFs/ETNs in the portfolio construction process, Christian Wagner, the Chief Investment Officer of Longview Capital Management, his thoughts. Wagner stated:
“There is no question that the volatility based securities traded parabolically last week. We witnessed an extreme shift in the volatility of the S&P 500 than is to be expected. Unfortunately, yesterday’s data is not a good gauge of how to measure tomorrow’s results, particularly as it relates to volatility. As of last week’s close, only 28 of the 500 components of the S&P 500 were in overbought territory, leaving a staggering 94% of the benchmark ‘oversold.’ Believing that volatility will remain constant at these levels and that increased volatility will presage a further increase simply is not a part of our strategy. Volatility hedges are a constant component in our strategy and we are using these price extremes to book some nice gains and rebalance our hedges.”
Will intraday volatility with such extreme swings as we saw last Friday resume this week and in the near future in the equity markets? The answer is perhaps, and if so, holders and traders of VIX related ETFs or ETNs should be quick to refine their current expectations of how these products function and normally “trade”. For a market environment where the VIX is trading with a $15 or $18 handle is starkly different than one where the VIX is trading in the $30s, much less $39.25. That said, holders of VIX related ETFs or ETNs can potentially use this extreme intraday volatility to their advantage by taking the other side of such moves.
The problem is, the moves themselves, such as the VIX spike to $39.25 (where related products such as VXX traded at $33.25, VXZ traded at $57.78, TVIX traded at $40.65, and XIV traded at $10.57 for instance) can be extremely short-lived, and literally impossible to act on and aggressively trade against. Those who noticed that XIV traded at $10.57 on Friday and thought it a screaming buy (thus the VIX itself a screaming sale, since XIV is inversely connected to the VIX) were unlikely to have a chance to realistically buy XIV shares at $10.57, or even if they tried to pay all the way up to $11.00 and beyond because the VIX immediately regressed from the highs (taking VIX related ETF/ETNs with it), and simultaneously equity futures bounced from the intraday (and recent lows). The speed of these price movements and the levels of recent intraday price ranges compared to historical intraday ranges has surprised a great many in this market in short order, and thus market makers and liquidity providers such as high frequency trading firms have certainly “widened their parameters” when committing capital and trading against customer order-flow and in trading firm capital.
The extreme price volatility and speed of recent price movements has created potential trading opportunities, but for the average portfolio manager or investor, reaction time will likely just not be quick enough to realize a good trade when it presents itself. That said, a potential strategy to employ, especially if these conditions in the equity market continue, with daily “macro” headline risk existing in the marketplace and influencing the tape to a large degree, would be one of “bracketing” buy and sell orders at what would normally seem like “well away” orders, either on a “Day” or “GTC (Good Till Cancelled)” basis. For example, selling VXZ last Friday anywhere above $57.00 or buying XIV below $11.00 now look like fantastic intraday trades, based on the fact that the moves to those extremes was so short lived, and an immediate price regression in the opposite direction occurred just as these levels were touched.
However the only realistic way for holders or users of these VIX related ETFs and ETNs to book large intraday gains by taking the other side of such extreme moves is to put out limit orders on either side of the book (Buys or Sells), at some “factor” around the current levels of where the products are trading themselves. The price levels orders should be put out at should not be completely unrealistic, i.e. trying to sell VXZ at $100 on an intraday basis with the product trading in the $50s is very unlikely to yield good results, but at the same time can be “wider” than usual given the current market environment and the potential for short term gapping effects due to what seems like less liquidity being available in the overall marketplace during quick, unilateral price moves in the market indices. Then, by monitoring the VIX itself along with overall market activity, one can tighten or widen their parameters and sensitivity based on where the intraday patterns are themselves versus historical volatilities.
Last Friday’s extreme move in the VIX and related ETF/ETN products was a true eye opener to both institutional and retail users of these products, who should never lose sight of the fact that they are trading “volatility” as an asset class, or essentially “human” or the “market’s emotion” in the form of fear or complacency, and an asset as such, will certainly not always act rationally, if at all.
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