Era of Calm Ends as Volatility Returns to Markets

Sudden return of volatility nearly wipes out assets of some popular exchange-traded products that allow investors to bet on continued calm

Traders signal offers in the options pit Tuesday at the Cboe markets exchange.Photo: Scott Olson/Getty Images

By

Asjylyn Loder,

Gunjan Banerji and

Alexander Osipovich

Updated Feb. 6, 2018 7:40 p.m. ET

46 COMMENTS

Stocks rebounded Tuesday, a day after the Dow Jones Industrial Average suffered its biggest one-day point decline ever. But another round of wild price swings raised new questions about whether volatility was emerging as a threat to the nearly nine-year old bull market.

The Dow ended the day 2.3% higher after swinging 1,167.49 points from its intraday low to its high. The S&P 500 index, which lost nearly $1 trillion in market value on Monday, gained 1.7%, and the Nasdaq Composite rose 2.1%.

The sudden return of volatility nearly wiped out the assets of some popular exchange-traded products that allow investors to bet on continued calm.

Japanese securities firm Nomura HoldingsInc. and Swiss bank Credit SuisseAG announced Tuesday that they would close two exchange-traded products that saw more than 80% of their value erased when volatility spiked. U.S. exchanges temporarily halted trading in similar products.

Betting against wild price swings has been one of the most profitable trades in recent years as central bankers flooded the markets with cash and lulled investors with record-low interest rates. But Monday’s sharp decline in stocks, followed by an abrupt surge in an index measuring stock volatility that is known as Wall Street’s fear gauge, triggered a spectacular unraveling.

While the exchange-traded products were the most visible victims, other investors were similarly blindsided by the sudden surge in volatility. Tony Caine, founder and chairman of Chicago-based LJM Partners Ltd.—which focuses on volatility strategies—told investors in a letter Tuesday that “LJM strategies have suffered significant losses,” according to a copy of the letter obtained by The Wall Street Journal.

“This is the volatility event that we’ve been waiting for,” said Chris Hausman, director of risk management and chief technical strategist at Swan Global Investments. “A lot of people have become complacent.”Something smells fishy - can they create the volatility that they have been waiting for?

Before the abrupt reversal, global stocks had climbed higher in 2018 amid a drumbeat of positive economic news, including corporate tax cuts, rising wages and strong company earnings. Investors in January poured $102 billion into mutual funds and exchange-traded funds that invest in stocks globally, according to Bank of America Merrill Lynch. The steady upward march prompted more investors to bet that the Cboe Volatility Index, a measure of traders’ expectations for market moves, would remain near record lows.

“A lot of people have never seen a bear market,” said Melissa Brown, managing director and head of applied research at Axioma. “These big events scare a lot of people and then it becomes a self-fulfilling prophecy.”

Nowhere was the market’s change in sentiment more glaring than in Wall Street’s fear gauge. The volatility index, known as the VIX, spiked in unusual late-day trading Monday afternoon. The price of futures pegged to the VIX nearly doubled Monday, with much of the increase occurring in just 15 minutes of afternoon

More on the Market Tumult
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  • Market’s Big Bet on Calm Turns Ugly
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The VIX was invented 25 years ago as a way to warn investors of an imminent crash, but it has since morphed into a giant casino of its own. The measure uses options on the S&P 500 stock index to measure traders’ expectations for near-term market swings.

The advent of VIX exchange-traded products in 2009 made it possible for investors to trade volatility alongside the most sophisticated hedge funds in the world. Since the VIX rises when stocks fall, it made an attractive form of insurance in the aftermath of the financial crisis. YES, A HEDGE!!!!!

Investors flooded into products that profit when volatility rises. But fear faded as the market pushed steadily higher, and those products hemorrhaged money. So instead of buying insurance, investors started selling it. Some placed their bets directly in futures and options, while others bought into exchange-traded products that profit when VIX futures decline. SELLING INSURANCE IS SELLING OUT OF MONEY PUTS ON THE MARKET Click Here?

The strategy has been enormously profitable as the stock market surged and volatility remained muted. Both the ProShares and the VelocityShares products more than doubled in the 12 months ended Feb. 1.

Since the start of the year, the ProShares Short VIX Short-Term Futures ETF and the VelocityShares Daily Inverse VIX Short-Term exchange-traded notes—the two largest short-VIX products—took in $2.2 billion combined, nearly doubling their combined assets to more than $4 billion as of Feb. 2, according to FactSet.

But those strategies amplify stock losses when markets turn, as investors learned Monday night, when both the ProShares and the VelocityShares products lost more than 80% of their value in after-hours trading.

The losses were triggered by a late-day surge in VIX futures prices. A series of massive buy orders flooded into the futures market after the close of the U.S. stock market at 4 p.m. in New York. The VIX futures market closes 15 minutes later. In those final moments, VIX futures surged to $33.20, more than double where they had started the day, according to data from FactSet.

Nick Ravo says he owned the VelocityShares product in his retirement account, and watched as his investment was almost completely erased.

“I watched it sink, sink, sink after hours,” he said.

After settling at $99 a share, the VelocityShares product was worth $4.22 a share by Monday evening. On Tuesday morning, Credit Suisse announced that it would shutter the product on Feb. 21.

Trading was temporarily halted Tuesday morning in the ProShares ETF. When trading reopened, shares were at $11.70—an 88% drop from the start of trading on Monday.