How Two Tiny Vol Products Helped Fuel Sudden Stock Slump

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Yet the popularity of these vehicles might have contributed to one of the most violent moves in USA equities in history: one that saw the Dow Jones Industrial Average slump more than 6 percent in a span of six minutes.

But not all investments are bouncing back so easily. In the aftermath of an unexpected volatility explosion, Credit Suisse is moving to terminate the VelocityShares Daily Inverse VIX Short-Term ETN (NYSEArca: XIV).

And while high-frequency trading does often exacerbate volatile markets, Themis Trading's Arnuk said this week's turmoil didn't begin there.

Derivatives contracts tied to the VIX - known as the "stock market's fear gauge" - have grown rapidly in recent years as central bank stimulus and a recovering global economy lowered volatility across asset classes.

Thus, as the futures contracts move day-by-day toward expiration, the value of those contracts declines, so the VXX value itself decays to the tune of 30% per year. It lost nearly 100% of its value after the market closed on Monday.

Even though the stock market sell-off has reversed, the VIX remains at higher-than-average levels on Wednesday.

"The XIV ETN activity is reflective of today's market volatility", Credit Suisse VelocityShares spokeswoman Nicole Sharp said in a press release, "There is no material impact to Credit Suisse".

The products seek to provide inverse exposure to VIX short-term futures and, when that measure spikes, the investment loses value, at which time ETP issuers could liquidate the shares.

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There are some similarities to the volatility trade and the "short volatility" trades actually creating moves in the underlying equity markets being similar to credit default swaps (CDS) ahead of and during the financial crisis of 2008 to 2009.

The blow-up was the culmination of a long-running and wildly popular short volatility trade that was one of 2017's most profitable. These funds reset every day.

Michael Iachini, head of ETF research at Charles Schwab Investment Advisory recently outlined the problem using simple math. VIX Mid-Term Futures ETN Ipath (VXZ) now has a 14-day Commodity Channel Index (CCI) of 143.76.

At the time of writing, S&P 500 Dynamic VIX ETN Ipath (XVZ) has a 14-day Commodity Channel Index (CCI) of -180.02.

Selling a cash-secured put is a strategy that allows an investor to be paid a premium for the obligation to buy a particular stock at a fixed price in the future, usually for less than the current price.

And shares of CBOE Global Markets, which owns the Chicago Board Options Exchange, fell more than 10 percent Tuesday on investor concern that the failure of products like the VelocityShares note might make other volatility-related products less popular. Investors may be mindful of any meaningful pullback or correction, and they may have a certain percentage in mind for when things seem to be getting out of hand. They may look to the 50-day or 20-day to get a better grasp of what is going on with the stock in the near-term.

It may be time to start reading the prospectus.

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