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Volatility ETF Crash: Important Takeaways

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The market had been unusually calm over the past few years, making shorting the CBOE Volatility Index or the VIX—also known as the market’s fear gauge—one of the very popular trades. Bets against volatility had doubled in 2017.

But the trend reversed this year. On Monday, VIX soared 115% to its highest level in more than two years.  It was the biggest spike for the index since its inception.

And the two very popular products that allowed investors to bet against volatility—the VelocityShares Daily Inverse VIX Short-Term ETN and ProShares Short VIX Short Term Futures ETF (SVXY - Free Report) plunged more than 90%.

On Tuesday, Credit Suisse announced it would liquidate its ETN—XIV on February 21.

At one point, this product had $2.2 billion in assets. Many investors thought it was an easy trade and poured money into it without understudying its complex structure.

These two products were short bets on volatility. When volatility spiked, they lost value and to cover their short positions, they had to buy back the product they shorted initially--in this case VIX futures--in a large number, which further exacerbated the surge in volatility.

Both of them use VIX futures contacts. VIX futures contracts are usually in contango, i.e. later dated contracts are more expensive than near dated contracts, but there have been occasions when they were in backwardation.

At the time of rolling over, they sold more expensive contacts and bought cheaper near dated contacts.

Long volatility products, on the other hand, experience decay in value due to contango.

Investors should remember that leveraged and inverse ETFs and ETNs are highly complex financial instruments, which should be used only by the professional traders or sophisticated investors who understand them properly.

They are designed to achieve their stated performance goal on a daily basis. Over a period longer than one day their performance can differ significantly from their stated daily performance objectives.

According to XIV prospectus, "The long term expected value of your ETNs is zero."

The ETN structure made XIV more complex. The provider could activate call notice if the note’s value fell to less than 20% of the prior day’s closing value.

(See: ETFs Vs. ETNs--What Investors Need to Know)

To learn more, please watch the short video above.

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