2018 could be the year that volatility comes back with a vengeance.
Some market watchers blame the breakdown of these esoteric investments for exacerbating volatility and accelerating Monday's sell-off in particular, when the S&P 500 lost 4.1 percent.
"The short-volatility trade needed to be covered as volatility rose".
But it appears it is paying off in a big way with the VIX spiking at 37 after the Dow Jones recorded its biggest points drop of all time.
Monday's trading action saw the Dow drop 4.6 percent, to 24,345.75 - or 8.5 percent from its all-time high. At this point it is still a sorting out kind of process. The equity selloff has investors changing their bets on the likely path of Federal Reserve rate increases, with the market implied odds of hikes later this year easing.
On Friday, the Labor Department reported that employers added more jobs in January than economists had forecast.
Dave Roberts, an independent trader of volatility products and associated derivatives, noted that at the expiry of the January VIX contract, the front and second-month contracts were trading at a fairly narrow spread, in contrast to the wider gap at the December expiry.
The last time the VIX was at these levels, markets were spooked by fears of a slowdown in China.
While the stock market sell-off has statistical comparisons to previous market declines on a percent basis, it is the move in volatility that is the statistical anomaly. Credit Suisse, the company behind the products, said they were pulling the plug on them Tuesday morning.
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"Overall, I think for long-term investors, it's a drastic mistake to overreact to volatility that sometimes is a healthy dose of medicine".
To market analyst Mark Spitznagel, president and chief investment officer at Universe Investments, there is a more stealth factor at play. Investors must now determine whether exposure to stocks carries more risk than reward.
As stock markets around the world continue into their third day of plunges, the VIX has only been this high on three prior occasions. Looking over this market correction, people seem to be focusing on several factors that might have helped lead to it, including bets by some investors on continued low volatility that blew up when volatility started to spike over the last week.
"The concerns are that this could impact CBOE's VIX's volumes", said Richard Ripetto, an analyst at Sandler O'Neill + Partners.
The VIX's long-term average stands at 19.34. They have steadily risen in a well-behaved manner and haven't done much to scare the horses.
iPath S&P 500 VIX Short Term Futures ETN: (NYSEARCA:VXX) Designed to offer exposure to the S&P 500 VIX Short Term Futures Index Total Return. Not too many funds are strictly rules-based, he said. The volatility tax transformed what looked like an impressive return into a not-so-impressive 0% compound (or geometric) return.
SVXY, for its part, lives to fight another day - albeit with massive losses. Stocks didn't react much last month when the government shut down for a short time. Stocks have historically offered some of the biggest returns over the long term for investors.
Markets have enjoyed a six-year run without a sell-off exceeding 4%, Morgan Stanley's Andrew Sheets and his team of international strategists observed in a February 6 research piece.
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