SteadyOptions is an options trading forum where you can find solutions from top options traders. TRY IT FREE!

We’ve all been there… researching options strategies and unable to find the answers we’re looking for. SteadyOptions has your solution.

The Lessons From the XIV Collapse


The popular short volatility product XIV will liquidate after the harrowing after-hours decline. Credit Suisse has officially announced that the XIV has reached an acceleration event. This is a very bad outcome for anyone who owned one of these products such as XIV, SVXY, VMIN, EXIV, IVOP, XXV, and ZIV.

How short volatility products work?
 

If you’re long volatility then you make money when the VIX index or the volatility index goes up. The opposite happens if you’re short volatility. When you’re short volatility, you make money when the VIX index goes down, and you lose money when the VIX index goes up.

Vance Harwood provided a good explanation how XIV works here:

  • XIV trades like a stock.  It can be bought, sold, or sold short anytime the market is open, including pre-market and after-market time periods.  With an average daily volume of 29 million shares, its liquidity is excellent and the bid/ask spreads are a penny. 
     
  • Unfortunately, XIV does not have options available for it.  However, its Exchange Traded Fund (ETF) equivalent, ProShare’s SVXY does, with five weeks’ worth of Weeklys with strikes in 50 cent increments.
     
  • Unlike stocks, owning XIV does not give you a share of a corporation.  There are no sales, no quarterly reports, no profit/loss, no PE ratio, and no prospect of ever getting dividends.  Forget about doing fundamental style analysis on XIV.  While you’re at it forget about technical style analysis too, the price of XIV is not driven by its supply and demand—it is a small tail on the medium-sized VIX futures dog, which itself is dominated by SPX options (notional value > $100 billion).
     
  • The value of XIV is set by the market, but it’s tied to the inverse of an index (S&P VIX Short-Term Futurestm) that manages a hypothetical portfolio of the two nearest to expiration VIX futures contracts.  Every day the index specifies a new mix of VIX futures in that portfolio.  This post has more information on how the index itself works.
     
  • XIV makes lemonade out of lemons.  The lemon in this case is an index S&P VIX Short-Term Futurestm that attempts to track the CBOE’s VIX® index—the market’s de facto volatility indicator.  Unfortunately, it’s not possible to directly invest in the VIX, so the next best solution is to invest in VIX futures.  This “next best” solution turns out to be truly horrible—with average losses of 5% per month.   For more on the cause of these losses see “The Cost of Contango”.

This situation sounds like a short sellers dream, but VIX futures occasionally go on a tear, turning the short sellers’ world into something Dante would appreciate.

Most of the time (75% to 80%) XIV is a real money maker, and the rest of the time it is giving up much of its value in a few weeks—drawdowns of 80% are not unheard of.   The chart below shows XIV from 2004 using  simulated values.
 

XIV-sim-560x400.jpg
 

Understand that XIV does not implement a true short of its tracking index.   Instead, it attempts to track the -1X inverse of the index on a daily basis and then rebalances investments at the end of each day.  For a detailed example of what this rebalancing looks like see “How do Leveraged and Inverse ETFs Work?”

There are some very good reasons for this rebalancing, for example, a true short can only produce at most a 100% gain and the leverage of a true short is rarely -1X (for more on this see “Ten Questions About Short Selling”.  XIV, on the other hand, is up almost 200% since its inception and it faithfully delivers a daily move very close to -1X of its index.

 

What happened on February 5?

The Astonishing Story Behind XIV Collapse by Ophir Gottlieb provided a fascinating description of events leading to XIV collapse. The collapse was caused by huge increase in VIX index and forced liquidations caused by margin calls. Those liquidations triggered the Acceleration event, as outlined in the Prospectus:

Quote

As discussed in more detail under “Specific Terms of the ETNs—Acceleration at Our Option or Upon an Acceleration Event” in this pricing supplement, an Acceleration Event includes any event that adversely affects our ability to hedge or our rights in connection with the ETNs, including, but not limited to, if the Intraday Indicative Value is equal to or less than 20% of the prior day’s Closing Indicative Value.


License to Print Money?

XIV and SVXY were not bad products. The problem is not the product. The problem is how you use it.

There is nothing wrong to maintain constant long exposure to XIV or SVXY. Over the long term, it is a winning strategy.
 

Nowhere was the pain more palpable than on Reddit’s “Trade XIV” group, which counts more than 1,800 members. One of them goes by the cyber-handle Lilkanna, and to say he’s had a rough stretch would be a huge understatement.

“I’ve lost $4 million, 3 years worth of work, and other people’s money,” he wrote in a post that’s garnering lots of attention. “Should I kill myself?”

 

“I started with 50k from my time in the army and a small inheritance, grew it to 4 mill in 3 years of which 1.5 mill was capital I raised from investors who believed in me,” Lilkanna explained, adding that those “investors” were friends and family.

“The amount of money I was making was ludicrous, could take out my folks and even extended family to nice dinners and stuff,” he wrote. “Was planning to get a nice apartment and car or take my parents on a holiday, but now that’s all gone.”
 

The Problem? Leverage, Leverage, Leverage!

 

When people make those kind of returns, it is pretty clear they are taking too much risk.

Too much risk == too much leverage == position sizing too big.

Imagine you make 10 trades. The first 8 trades make 40% each, and the last 2 trades lose 90% each.

if you allocate 10% for each trade, your account is still up 14%. But if you allocated 50% of your account (not to mention 70-80%), your account is toast.

This is what happened to those poor XIV traders.

The problem is not limited to retail traders. We all remember the Karen Supertrader story. Those who are not familiar with the story:

Here is another example.
 

Mutual fund LJMIX, ran by Chicago based firm LJM Partners. They sell strangles on the S&P futures.

 

This is their track record before this move:

track.png


Excellent track record, but look what happened on Monday:

 

track4.png

track2.png 

 

And yesterday:
 

track3.png

 

Once again: The biggest problem is not the strategy. It is leverage. It is sad that even billion dollar hedge funds fall into the trap.
 

What Is SteadyOptions?

Full Trading Plan

Complete Portfolio Approach

Diversified Options Strategies

Exclusive Community Forum

Steady And Consistent Gains

High Quality Education

Risk Management, Portfolio Size

Performance based on real fills

Try It Free

Non-directional Options Strategies

10-15 trade Ideas Per Month

Targets 5-7% Monthly Net Return

Visit our Education Center

Recent Articles

Articles

  • Fear of Options Assignment

    One of the most common fears in option trading is one of early assignment.  The fear of having a large number of shares (or a large short position) coupled with a potential margin call (or Reg-T call) causing a sudden shortage of cash in their accounts worries investors.  Investors commonly view assignment as a huge potential risk.

    By cwelsh,

    • 0 comments
    • 74 views
  • The Value of Equity Asset Class Diversification

    This investing lesson is a tale of two time periods that highlight the important role of equity asset class diversification and systematic rebalancing in an equity fund portfolio.  Human nature is a failed investor, when our natural instinct is often to do the exact opposite of what we should do in practice.

    By Jesse,

    • 0 comments
    • 94 views
  • Lessons from Bill Ackman's comeback

    Bill Ackman is an American investor, hedge fund manager and philanthropist. He is the founder and CEO of Pershing Square Capital Management, a hedge fund management company. Ackman is considered by some to be a contrarian investor but considers himself an activist investor.

    By Kim,

    • 0 comments
    • 455 views
  • Exercise Risk of Uncovered Calls

    Exactly how risky are uncovered calls? That depends … Some traders avoid uncovered calls altogether because the risk can be significant, even unlimited (in theory). Others can rationalize this strategy as only moderately risky based on how you pick expiration and strike.

    By Michael C. Thomsett,

    • 0 comments
    • 162 views
  • Cash is (no longer) Trash

    According to www.bankrate.com, the current national average interest rate on bank savings accounts is only 0.10%. Many banks have barely budgeted on increasing interest rates even as the risk-free rate of return on a US Treasury Bill is currently in excess of 2%. This spread is a substantial profit margin for banks.

    By Jesse,

    • 0 comments
    • 260 views
  • The Danger of False Signals

    Everyone has heard about the troubling “false signals,” a price-based reversal indicator that shows up but does not lead to reversal. This is frustrating and expensive, but the problems in how traders react to false signals can be managed effectively with a few techniques.

    By Michael C. Thomsett,

    • 0 comments
    • 331 views
  • How Earnings Impact Options Prices

    Yesterday I closed our SE May 22.5 buy-write for a couple of reasons. First off, I knew that the position only had ~$0.20 more to gain over the next three weeks. I also knew those gains would take some time to capture as out-of-the-money puts (which is essentially what the May 22.5 buy-write is) hold their value until right before expiration.

    By Jacob Mintz,

    • 0 comments
    • 220 views
  • Options in the Media

    In general, financial reporting is a scam.  The daily highlights of “President Trump had eggs for breakfast causing futures traders to worry as markets decline slightly” or “Markets up on Mickey Mouse’s birthday,” always amaze me at the abject lack of correlation. 

    By cwelsh,

    • 0 comments
    • 276 views
  • Steady Momentum ETF Portfolio

    Last May, I wrote an article about how to analyze an investment strategy. Today I’ll use the concepts from that article to explain how the Steady Momentum ETF Portfolio (available as a bonus strategy to Steady Momentum subscribers) meets the criteria described in that article.

    By Jesse,

    • 0 comments
    • 409 views
  • Where to Find Exceptional Trading Data?

    Options traders are “data wonks,” meaning we all rely on information to make what we hope are informed decisions. But how do you know the difference between valuable and reliable data on the one hand, and rumor or speculation on the other?

    By Michael C. Thomsett,

    • 0 comments
    • 462 views

  Report Article

We want to hear from you!




Create an account or sign in to comment

You need to be a member in order to leave a comment

Create an account

Sign up for a new account. It's easy and free!


Register a new account

Sign in

Already have an account? Sign in here.


Sign In Now

Options Trading Blogs