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 is deeply risky.
This could be "the most dangerous trade in the world," according to macro strategist Boris Schlossberg of BK Asset Management. 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. 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.
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. However, the creation of VIX futures in 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.
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 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. 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.
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.
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.
As for Schlossberg, his warning about the product is based on his view that volatility is set to rise from its current, ultralow levels. In fact, "negative" may be putting it mildly. 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. The dollar was volatile in Friday trading but could catch a bid next week ahead of the employment report. Stocks fell after a report that Michael Flynn was directed by Trump to talk to Russians sent investors on a wild ride.
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Trading Nation is a multimedia financial news program that shows investors and traders how to use the news of the day to their advantage. This is where experts from across the financial world — including macro strategists, technical analysts, stock-pickers, and traders who specialize in options, currencies, and fixed income — come together to find the best ways to capitalize on recent developments in the market.
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