NEW YORK (Reuters) - New Jersey based independent trader, DJ Thompson, saw five months of profit burned away in one session on Monday, after bets on high-risk low-volatility stock market products went up in smoke as the broader U.S. equity market swooned.
“I took some losses,” said Thompson, who had a five-figure position in options that lost money as volatility spiked. “It’s certainly a bad scene out there for many investors.”
Despite a steady rally in the past 12 months that saw the U.S. benchmark S&P 500 stock index gain nearly 20 percent last year, retail and institutional investors were lured into using complex exchange traded products (ETPs) to reap even bigger gains by betting against a correction in prices, based on the volatility index offered by Cboe Global Markets, commonly known as Wall Street’s “fear gauge”.
The slump in U.S. stock prices which began on Friday, as bond yields rose with inflation fears after better-than-expected labor market data, led to massive unwinding of short position in VIX related products and some industry calls for tighter regulation.
After massive losses, two banks, Credit Suisse and Nomura, announced the shuttering of their respective Exchange Traded Note (ETN) products that bet on lower volatility. Trading in several other volatility-linked exchange traded products were also halted.
Shorting volatility, or betting on calm stock market conditions, has long been the mainstay of institutional players, but the introduction in recent years of volatility-linked exchange-traded products opened this strategy to retail players.
“Unfortunately a lot of people who are new to volatility had no idea of the risk,” said Thompson.
Credit Suisse said on Tuesday it would terminate the second-largest publicly traded product tracking swings in the S&P 500 index after its value plunged during the recent selloff in global markets.
VelocityShares Daily Inverse VIX Short-Term Exchange-Traded Note (ETN), which tracks financial instruments that bet against a fall in markets, will stop trading by Feb. 20, the Swiss bank said in a statement.
The notes were worth a combined $1.6 billion on Friday, according to Thomson Reuters’ Lipper unit, but the redemption after Monday’s selloff will likely leave investors with a fraction of their initial investment.
The bank’s exposure to the product, which Credit Suisse launched in 2010 and of which it has around 4.8 million units, was fully hedged, meaning they made other trades to eliminate their own risk, according to a source familiar with the matter.
Deutsche Bank is another top holder of the notes with a little over 4 percent of the shares, according to Morningstar Inc data. Big institutional players are likely to have hedged their exposure to the notes, market participants said.
“I don’t think this is going to blow up the banks,” said Connecticut-based Stephen Aniston, president of investment adviser Black Peak Capital, that focuses on VIX products.
It is the relatively newer entrants to this market who are likely to be hurting from the implosion of these products, market participants said.
BlackRock Inc, the world’s largest asset manager, on Monday warned of the risk of inverse exchange-traded products.
While these short volatility products are marketed as complex and risky products aimed at sophisticated investors who are cognizant of the risk they are undertaking, the success of these products has reeled in a lot of retail interest.
Just one fifth of the outstanding shares in these products are owned by funds and institutions, according to Morningstar Inc, suggesting the product could be extensively owned by retail investors.
“The reality is that we trade in a market where everyone has equal access,” Randy Frederick, vice president of trading and derivatives for Charles Schwab in Austin, Texas.
“Even if you design a product that is intended for sophisticated traders, hedge funds, or institutions or whomever, if you don’t somehow separate them from trading on an exchange, then every retail investor who wants to get into them, can.”
“That’s what happened,” he said.
Market participants said there has been a surge in retail interest in these products in recent months.
“Over the last six months, hedge funds pulled back and retail money came in,” Black Peak Capital’s Aniston said.
Exchange traded products (ETPs) such as VelocityShares Daily Inverse VIX Short-Term ETN, the ProShares Short VIX Short-Term Futures ETF, which profit from low volatility, drew in billions of dollars over the last year and their net short exposure hit a record high on Thursday.
Charles Schwab’s Frederick said the extent of losses faced by investors could lead to regulators reexamining these products’ suitability for retail players.
“That would not surprise me,” he said.
Reporting by Saqib Iqbal Ahmed; Additional reporting by Trevor Hunnicutt; Editing by Daniel Bases and Clive McKeef