Friday, February 9, 2018

Oh my goodness this is complicated

I'm not in finance.

I'm a software engineer.

But, really, the two professions are not all that far apart.

So I feel like I ought to be able to grasp some of the most basic aspects of finance.

But this baffles me: Volatility Jump Has Traders Asking About VIX Note Poison Pill:

An ETP meant to mirror moves in the front of the VIX’s futures curve plunged more than 75 percent in after-hours trading following an 80 percent spike in contracts that comprise its underlying index during the trading day, potentially putting in play triggers that would enable the fund’s owners to liquidate it to avoid losses.

OK, so an "ETP" is an "Exchange Traded Product":

Exchange-traded products (ETP) are a type of security that is derivatively priced and trades intra-day on a national securities exchange. ETPs are priced so the value is derived from other investment instruments, such as a commodity, a currency, a share price or an interest rate. Generally, ETPs are benchmarked to stocks, commodities or indices. They can also be actively managed funds. ETPs include exchange-traded funds (ETFs), exchange-traded vehicles (ETVs), exchange-traded notes (ETNs) and certificates.

(Please ignore the acronym defined in terms of other acronyms, for now)

And the VIX is the "Volatility Index":

VIX is the ticker symbol for the Chicago Board Options Exchange (CBOE) Volatility Index, which shows the market's expectation of 30-day volatility. It is constructed using the implied volatilities of a wide range of S&P 500 index options. This volatility is meant to be forward looking, is calculated from both calls and puts, and is a widely used measure of market risk, often referred to as the "investor fear gauge."

But what actual ETP's are we talking about, here? Well, here they are: Comparing VIX ETFs/ETNs (XIV, SVXY)

The VIX (CBOE Volatility Index) was created in 1993 to measure the 30-day implied volatility using at-the-money S&P 100 Index option prices. In 2003, the VIX was calculated based on the S&P 500 Index, and it seeks to estimate future volatility by averaging the weighted prices of S&P 500 options over an array of strike prices. Rather than trading options or futures on VIX, sophisticated investors may consider exchange-traded products (ETPs) linked to the VIX, such as the VelocityShares Daily Inverse VIX Short-Term ETN (NYSEARCA: XIV) and the ProShares Short VIX Short-Term Futures ETF (NYSEARCA: SVXY).

Uhm, er, ok. All clear now?

Well, some people weren't: Volatility Inc.: Inside Wall Street’s $8 Billion Mess

The fallout from the implosion of this vast array of arcane bets mounted quickly on Tuesday. Credit Suisse moved to liquidate one investment product and more than a dozen others were halted after their values sunk toward zero.

The meltdown began last week when stocks started to plunge and volatility spiked to levels not seen since 2015. The VIX -- officially, the Cboe Volatility Index -- surged to 50 on Tuesday, before dropping to 30.

Well, don't feel bad. This is hard for everyone, I think.

Matt Levine takes a swing at it: People Are Worried About the Stock Market

The CBOE Volatility Index, the VIX, is a measure of short-term expected volatility in the S&P 500 Index; it closed at 17.31 on Friday and 37.32 on Monday. That is a 115.6 percent move, but, eh, you know, it is also a 20 percentage point move, and off a pretty low base.

But the great thing about modern finance is that it inexorably turns abstract quantities into prices. The VIX is not investable -- you can't buy the VIX for $17.31 or whatever -- but you can get pretty close. For instance there are VIX futures, and exchange-traded products based on those futures that attempt to capture the daily changes in the level of the VIX. If you owned the iPath S&P 500 VIX Short-Term Futures exchange-traded note (ticker VXX), then you were up ... huh, well, 33.5 percent yesterday, a nice day but not quite the 115.6 percent gains you might have hoped for. (The VXX "continued to climb in post-market trading, shooting up as much as 48 percent since the close.").

If on the other hand you owned the VelocityShares Daily Inverse VIX Short-Term ETN (ticker XIV), or the ProShares Short VIX Short-Term Futures exchange-traded fund, which are meant to provide the inverse of the daily VIX performance, then you were ... hmm ... [rechecks calculations] ... yes it says here you were down 115.6 percent yesterday? I mean, you weren't. For one thing your downside is limited to 100 percent; you can't owe the ETN more money than you invested.

"Your downside is limited to 100 percent."

OK, that part I understand.

It's still pretty complicated, though.

Pseudonymous blogger Kid Dynamite takes a swing at it, too: $XIV Volpocalypse – A Sea of Disinformation and Misunderstanding

There are multiple kinds of ETPs (Exchange Traded Products).

ETFs (Exchange Traded Funds) are generally easy to understand: the ETF holds a basket of stocks (or something else), and there are APs (Authorized Participants) who can bring that basket of stuff to the issuer in exchange for new ETF shares, or bring the shares of the ETF to the issuer in exchange for the basket of stuff. This “creation/redemption” mechanism allows arbitrageurs to keep the trading price of the ETF very close to its NAV (net asset value). If the ETF trades rich (above NAV), the arbs will short the ETF, buy the basket of stuff, and create new shares by delivering the stuff to the ETF, closing out their short. If the ETF trades cheap (below NAV), arbs will buy the ETF, short the basket of stuff, and bring the ETF to the manager, receiving the basket of stuff to close out their short. Simple, right?

Then we have CEFs (Closed End Funds), which don’t have this creation/redemption mechanism. Some of them have a provision where shares can be redeemed, sometimes only at specific fractions of NAV, but with CEFs there are no Authorized Participants who can create new shares to arb situations where the CEF trades rich to its NAV.

Finally we have ETNs (Exchange Traded Notes), which are debt instruments of an issuer, whose value is tied to some underlying formula based on the performance of specific assets. With ETNs, as with CEFs, it is often only the issuer who can create new shares to arbitrage situations where the ETN is trading rich. Many ETNs also have redemption mechanisms where holders can deliver shares (in minimum block sizes) to the ETN in exchange for the underlying assets or value thereof.

Is this helping? I dunno.

Kid Dynamite himself acknowledges that this is some pretty abstract stuff, and suggests that you might have an easier go of it with an older article that he wrote: A Leveraged ETF Trading Flow Case Study: Gold Miners – $GDX $NUGT $DUST

There’s a triple leveraged INVERSE ETF – $DUST (no positions) – which seeks to deliver negative 3 times the daily return of the same index. Here’s another confusing part for some people – its rebalance flows are in the same direction, even though it’s leveraged short. Let’s walk through it, shall we?

$DUST had $209 MM in assets as of 9/30/14. That means they’d need -3*209 = -$627 MM in (short) exposure to the GDX. Today, GDX was up 6.7%, so their short hedge portfolio is now worth $42 MM more (a loss of $42 MM for $DUST), or -$669 MM (their short went up in gross notional value). Their assets are now $209 MM – $42 MM = $167 MM. For the new (tomorrow) assets number of $167 MM, they’d need -3*167 = -$501 MM in exposure – so they need to COVER $168 MM in short exposure. In other words, the leveraged short ETF ends up short too much exposure when the underlying index goes higher, so they need to cover some of their short.

"Triple-leveraged inverse ETF".


And I've studied mathematics most of my life!

OK, one more time, back to the ever-patient, ever-accurate, ever-useful Matt Levine, the best financial writer ever to write a daily blog: Are Banks Worthless?

the XIV is just, you know, it is complicated, there are formulas in the prospectus, etc. Another complaint is that its complication might have caused it to blow up. Actually "might" is too weak a word; as Charles Forelle pointed out, the prospectus says, bold and underlined, that "the long term expected value of your ETNs is zero." Even if the VIX goes down, the XIV -- which is a bet on the VIX going down! -- will also lose money over time. If you bought XIV to bet on vol going down, and vol went down, and you lost money anyway, you might be aggrieved. "What a complicated product," you might complain, correctly, even though you were warned.

But what actually happened is that on Monday the VIX went up by 116 percent, and the XIV went down by 93 percent, and Credit Suisse AG, XIV's sponsor, announced that it would usher XIV off into the great financial-products hereafter. If you bought XIV to bet on vol going down, and vol more than doubled in a day, then you get up from the table, you shake everyone's hand, you say "well played XIV," and you walk away with dignity. You did that! That's on you. Perhaps you didn't understand the intricacies of the formulas in the prospectus, but the intricacies of the formulas didn't matter. You made a bet on the VIX going down, the VIX went up by 116 percent, you lost. That is that.

Let's see if I got this:

  1. Stock prices were remarkably stable, mostly going up, but basically not going up or down very much.
  2. People figured out a way to speculate on stock prices continuing to go up, or at least on stock prices not going up or down very much
  3. They made money on those speculative trades, enough money that they went and borrowed large amounts of additional money, in order to make more money.
  4. Then stock prices went down. A lot.
  5. And those people were sad.

You know, in some ways I think I'm smarter after all of this.

In other ways, I think, not.

1 comment:

  1. The only bit that makes sense is that the inverse of VIX has ticker XIV