TVIX and GAZ: Betting Against The Consumption Of This Free Lunch

 |  Includes: GAZ, TVIX
by: Paulo Santos

One of the most fantastic aspects about what happened in the VelocityShares Daily 2x VIX ST ETN (NASDAQ:TVIX) and the iPath Dow Jones UBS Natural Gas ETN (NYSEARCA:GAZ) was not the fact that uninformed traders bought those funds trading at huge premiums to their fair values. It was, rather, that informed traders also bought them, in the expectation that those huge premiums would get larger still.

Informed traders buying something that is clearly and unambiguously known to be mis-priced is truly surprising, on at least two counts.

One is that it shows the confidence in the capability to short squeeze shorts under any circumstance, even in a deeply irrational situation, is running high. It's quite different short squeezing shorts on something where the value is subjective, and the case can then be made that there is a possibility that the value might turn out higher, from short squeezing shorts on something where the value is objective, well-known, and is as much as half the price being paid. Thus, that informed traders knew this yet decided to participate in a short squeeze anyway, shows how incredibly confident they must be - I believe this to be the result of the never-ending actions by central banks to prop up markets on the long side. It has reached a point where the long side feels invincible, even in these clear situations.

But, most importantly, this betting on the increase of the premium is a bet that there's a free lunch, but it won't get eaten. Let me explain. These ETNs only divorced themselves from reality because their issuers decided to stop issuing new notes. The issuance of notes is part of the arbitrage mechanism that keeps the ETN quote near the ETN indicative value, because if it strays upwards then new notes are issued and sold in the market, bringing it back down again. But even though they suspended issuance, nothing really keeps the issuers from issuing new notes if they so decide.

It thus happens that when one of these funds is trading at a large premium (TVIX went over 80%, GAZ went over 160%), there's a free lunch in the issuer's optionality to start issuing new notes again. This means that the issuer can decide to issue new notes, and if he does so the accredited entities that can get those notes the said free lunch, because they'll be able to sell at the market quote (which has a huge premium to the indicative value) and buy at the indicative value (the new issuance).

So, any informed trader that's betting on the expansion of the irrational premium is thus betting that this free lunch won't get eaten. There won't be new issuance, in spite of there being free money to be made if issuance is resumed. As we've seen in TVIX in the last two days, though, that's a suckers' bet. Not only did Credit Suisse announce that it would be resuming issuance, but it seems clear that a lot of people (probably accredited to take advantage of such issuance) knew beforehand.

Regarding GAZ, pretty soon either the market will whittle down the premium by itself, or someone might decide that this lunch is also too tasty to pass up.

Disclosure: I am short GAZ.