The biggest losers in the stock market rout are people who made bets that would pay off only if the stock market remained calm—and then lost most of what they put in when stocks went kerflooey. On Reddit, it’s easy to find comments such as, “Didn't think this would blow up like it has.” One post, which can’t be verified, said, “Ive lost 4million USD, 3 years worth of work, and other people's money .”
This was, alas, perfectly predictable. Last summer I wrote an article for titled “Why Investors Shouldn’t Trust Low Volatility: Don’t let the long run of market calm lull you into complacency.” Plenty of other people issued similar warnings.
What kept investors flocking to the bets is that they did tend to make money in the short run. The trade-off for small, predictable monthly profits was the possibility of a huge, unpredictable loss. Essentially, investors were picking up nickels in front of a steamroller, to use an old expression popularized by the author Nassim Nicholas Taleb.
Here are the mechanics of the unfortunate bet on calm markets: The Chicago Board Options Exchange Volatility Index, or VIX, also known as the fear gauge, is a measure of market expectations of near-term volatility conveyed by the prices of options on the S&P 500 stock index. When markets seemed unnaturally calm over the past few years, some people invested in futures contracts that would pay off when the VIX went up.
When betting on higher volatility didn’t work out, some of those people switched around to bet on volatility to stay low or go even lower, using such exchange-traded products as the VelocityShares Daily Inverse VIX Short-Term exchange-traded note, whose ticker is XIV (VIX spelled backward). As I wrote last year, “An attraction for traders is that, because of the quirks of ‘rolling’ old futures contracts into new ones, inverse notes tend to make money even if the actual VIX doesn’t go anywhere.” Yes, that’s an example of picking up nickels in front of a steamroller.
The fact that the XIV crashed on Monday when the VIX rose wasn’t a flaw. It was precisely what the product was designed to do, as my Bloomberg colleague Matt Levine points out. Actually, though, the XIV contract didn’t fall far enough. When trading was halted, it traded for more than the value of its underlying assets. According to the VelocityShares website, XIV closed on Feb. 5 at $99 a share, but the “indicative” value was just $4.22 a share.
Now Credit Suisse Group AG, which issued XIV, says it’s buying back all of the outstanding notes as of Feb. 21. Credit Suisse happens to be the biggest holder of the notes, but said it hasn’t suffered any trading losses, presumably because its position was hedged. The same can’t be said for the individual investors who just got steamrollered.