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Money is rushing into ‘the most dangerous trade in the world’

It shouldn’t be too surprising that the XIV exchange-traded note, which is designed to deliver the inverse performance of the well-known CBOE Volatility Index (or the VIX) on a daily basis, is attracting fresh attention after surging as much as 87 percent this year.

But some caution that investing in the exchange-traded product now could be deeply risky.

This could be “the most dangerous trade in the world,” according to macro strategist Boris Schlossberg of BK Asset Management. “It’s already had a massive runup because we’ve had very low volatility,” but at this point, “it’s very likely that volatility is going to increase,” Schlossberg said Thursday on CNBC’s “Trading Nation.”

The product itself is simple — or at least, as simple as an exchange-traded note tracking futures tracking an index tracking options on an index can be.

The VIX itself uses the prices of options on the S&P 500 to measure expectations of how much the index will move over the next 30 days. Since options are more commonly used to hedge against market declines than to speculate on market rises, the VIX also tracks investors interest in buying short-term “portfolio protection,” which is why it is sometimes known as the market’s “fear gauge.” Recently, it has remained at very low levels, since the S&P 500 itself has seen notably muted moves.

When we go a step further, to products tracking the VIX that can be bought or sold, things get a little hairy. That’s because the level of the VIX itself is merely the output of a mathematical equation, rather than an index that tracks assets that are bought and sold. An investor who buys all the stocks in the S&P 500 at the right proportions will end up with a portfolio that performs very similarly to that popular index, but there is no direct way to buy the products tracked by the VIX.

However, the creation of VIX futures in 2004 gave traders a relatively straightforward way to play the index. The standardized contracts settle at the cash level of the VIX, meaning that they offer a way for traders to gain positive (long) or negative (short) exposure to the future level of the VIX. If a trader thinks the VIX will be higher on a certain future date than the overall market expects it will be, she can simply buy a futures contract.

The hitch here is that VIX futures track something different from the VIX itself, and thus can move differently from the index. As an example, let’s imagine that the country of Freedonia has decided to hold an election on Monday, and that the outcome will cause the market to move sharply in one direction or the other, but that the move will be constrained to Monday alone.

Since the VIX tracks expected moves over the next 30 days, this announcement should cause the VIX to rise sharply. But since the July VIX futures contract represents speculation about the level of the VIX on July 19, these futures may move less, or not at all.

A more general problem for VIX futures stems from the fact that the future is more uncertain than the present, and the far future is more uncertain than the near future. For this reason, VIX futures that settle far in the future trade at higher levels than VIX futures that expire in the near future, and VIX futures that expire in the near future generally trade at higher levels than the VIX itself. For instance, on Friday, the VIX is at 11.5, the July VIX futures are at 12.6, and the January 2018 VIX futures are at 16.5.

The creation of VIX futures, in turn, allowed for the creation of VIX-related exchange-traded products. By far the best known of these is the VXX, which is one of the 15 most popular exchange-traded products by dollar volume this year (according to a CNBC analysis of FactSet data).

Many investors and traders use the VXX as a highly convenient VIX proxy, but it’s worth noting that the VXX tends to work poorly as a long-term holding due to the structure of the futures market. Lacking the ability to directly track the VIX, the VXX strives to provide continual exposure to 30-day futures on the VIX. And since the futures expire every month, the managers of the VXX continually sell soon-to-expire VIX futures in order to buy longer-to-expire ones.

The problem is that the structure of the futures market causes those longer-term futures to lose value as they come closer to expiration — meaning that the VXX is forever engaged in the Sisyphusian task of selling something less expensive in order to buy something more expensive.

It should be no great surprise, then, that the VXX is down 48 percent year to date while the VIX itself has fallen 18 percent; last year, the VXX dropped 68 percent while the VIX declined 23 percent; the year before that, the VXX slid by 36 percent while the VIX was down 5 percent.

The same structure of the futures market that hurts the VXX benefits the XIV, which is an exchange-traded product that aims to deliver, on a daily basis, the inverse performance of the VIX. Since the XIV is continually engaged in the process of shorting appropriate amounts of the two soonest-to-expire VIX contracts, the managers of the XIV are perpetually buying back cheaper, sooner-to-expire VIX futures in order to short more of the more-expensive, longer-dated VIX futures. The headwind for the VXX becomes a tail wind for the XIV.

This year, the decline in the VIX has also been a tail wind for the XIV. All in all, the XIV has surged more than 70 percent this year, though it is off its late-June highs.

The rise in this product hasn’t escaped traders’ attention. In terms of the dollar value of shares traded, the short-VIX-futures XIV has actually surpassed the long-VIX-futures VXX.

“We think it’s especially interesting that there is now more XIV trading than VXX, perhaps pointing to the growing interest in shorting volatility among retail [investors] and others who are not specialists in volatility trading,” Pravit Chintawongvanich, head of derivatives strategy at Macro Risk Advisors, wrote in a Wednesday note to clients.

As for Schlossberg, his warning about the product is based on his view that volatility is set to rise from its current, ultralow levels.

“It’s simply a dangerous trade from a macro point of view,” he said Thursday. “As central banks begin to increase rates, we’re going to see more volatility, and this [product] is going to show some very negative days.”

In fact, “negative” may be putting it mildly. On a day when the VIX and the VIX futures double in value (perhaps due to bad news out of Freedonia), the VXX could easily double as well, while the XIV could perform the inverse move.

“One big thing that we’ve been highlighting is that this product can actually go to zero,” Chintawongvanich said Thursday on “Trading Nation.” “Right now the VIX is around 12 — just think of a scenario that takes the VIX from 12 to 20-plus in a single day. It’s not impossible. In that case the XIV could easily go to zero,” which is something “many investors in this product may not be aware of.”

Those who buy the XIV with money they cannot afford to lose, then, could be putting their portfolio in great danger indeed.

More generally, it may be the case that when it comes to products like the VXX and the XIV, the classic “know what you own” advice can be harder to follow. But if anything, that makes it even more important to heed.

VelocityShares, a subsidiary of Janus Henderson Group, manages XIV; representatives for Janus Henderson declined CNBC’s request for comment.

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