Until last week, the "buy stocks, sell volatility" trade was working
So much for profiting off of a calm but booming stock market.
The dramatic sell-off in stocks Friday and Monday forced a flood of buying in derivatives to close out on of Wall Street's biggest trades: while buying stocks, traders were betting against volatility, which has been near historic lows.
One way to make that bet was to buy an exchange traded note linked to the Cboe Volatility index, a widely watched but very inside baseball indicator of how Wall Street views risk in the stock market for the next 30 days. These ETNs were designed to deliver returns if volatility stayed low.
Until last week, the "buy stocks, sell volatility" trade was working. Stock markets had advanced double-digits last year and were up another 8 percent in January. But volatility, which had spent much of last year below 15, also began to spike up and on Monday it blew out to 37 while the S&P 500 fell 4 percent.
Then the trade didn't work anymore.
Credit Suisse will shut down one such volatility-linked ETN later this month after losing most of its value in Monday's market rout. The VelocityShares Daily Inverse VIX Short-Term ETN (XIV ), which had $1.9 billion before this week, is emblematic of Wall Street's thirst for a winning bet. For the year ending in January, it had more than doubled.
"You are picking up pennies and dimes in front of the steamroller, and you are eventually going to get steamrolled," said Peter Boockvar, the chief investment officer of Bleakley Financial Group. "Wall Street will invent anything to provide a casino for people to speculate until it blows up."
The Financial Industry Regulatory Authority has warned about volatility-linked ETNs and other exchange traded products. In October, it ordered Wells Fargo to pay investors $3.4 million for improper sales of the products.
The Wells Fargo sales team "mistakenly believed that the products could be used as a long-term hedge on their customers' equity positions in the event of a market downturn," Finra said.
In fact, the products are really meant for short-term speculation.
Unlike exchange traded funds that track an index by buying stocks in the same proportion as their targeted benchmarks, ETNs linked to volatility trade in VIX futures. In the case of the Credit Suisse ETN, it was selling the VIX futures one and two months ahead and the goal was to return the opposite of what the VIX did.
The strategy requires constant trading in VIX futures to keep on track, but it's not a strategy that works long-term. Many volatility-linked ETNs "have lost more than 90 percent of their value since they launched," Finra said in an investor notice in October. "And such products will likely continue to lose value over longer periods of time."
The VelocityShares ETN was down 94 percent Tuesday afternoon. Other exchange traded securities that bet on volatility were also halted on Tuesday after losing most of their value overnight. The ProShares Short VIX Short-Term Futures resumed trading late Tuesday morning down 90 percent.
The events weighed on the stock of the Cboe itself, down 10 percent on Tuesday as people worried about how its VIX-related trading volume and revenue will be affected by the implosion of these products. Research from KBW estimated that as much as 25 percent of Cboe Global Market's revenue is generated from VIX-related products.
Some analysts predicted a big unwind of volatility-tracking strategies by hedge funds and other traders caught with exposure they need to close out. Barclays estimated Volatility Target funds will sell about $225 billion worth of stocks in the next few days to reduce their leverage.
"The market is a casino on steroids" with these exchange-traded funds and exchange-traded notes, billionaire activist investor Carl Icahn told CNBC on Tuesday during an interview on " Halftime Report ." The products are the "fault lines" that will eventually lead to an earthquake on Wall Street, Icahn said.