Fear Of 'Fear Index' Tracking ETNs May Provide Opportunity

Includes: BCS, CBOE, CS, TVIX, VXX
by: Robert Weinstein

Shares in Chicago Board Options Exchange (CBOE) volatility index tracking ETNs fell again today on above normal volume. First in focus is Credit Suisse Group's Velocity Shares Daily 2X VIX (NASDAQ:TVIX) falling over 25% at the time of writing. Credit Suisse announced after trading yesterday it would issue more shares, creating some of the selling pressure today. Credit Suisse stated the reason for the decision to allow greater issuance of shares is in part because of heightened demand for the product. Recently shares traded for levels of near 20% higher than the net asset value underlying the shares. The premium paid for the ETN shares melted away though and in part before the announcement.

One has to wonder what came first, the chicken or the egg. Did some traders have inside information and profit from the announcement or was the decision of Credit Suisse a reaction to the drop in prices. If the announcement by Credit Suisse is a reaction to the drop in price, one has to wonder why an announcement would be necessary if the market was already self-correcting. Regardless if some traders made money from the announcement or not, TVIX appears to now be near the fair value so everyone received what they wanted, unless of course you are currently an investor with TVIX for longer than one day. In that case you're likely trying to apply bandages and pressure to the bleeding or ready to pull the emergency cord and get off this train.

How low can it go? An investment with TVIX could possibly go down to zero even if the VIX doesn't. I guess it "can" happen, but it is not likely. We know it can happen as there are Lehman Brothers creditors who lost big when they invested in ETNs underwritten by Lehman before they went bankrupt. Even if Credit Suisse ran into a liquidity problem it would be questionable if they would be allowed to fold the tent in the same way Lehman Brothers did. A more likely scenario would be closer to Bear Stearns and a buyout from another bank in my opinion. With Europe's economy as fragile as it is, I find it difficult to accept the ECB allowing what sure would be a massive domino effect of failures. It may not even be good long-term policy to allow insolvent banks to continue, but the alternative would be massive immediate pain and possible civil unrest as billions of euros of wealth would be wiped out. ECB vs. Swiss Central Bank? Yes, both in my opinion (along with the Fed) would likely not allow a failure of this size.

Along with TVIX which is meant to track at 2X the VIX, we have another product by another bank to trade volatility with a "stock." Barclays Bank offers the iPath S&P 500 VIX futures tracking ETN with a ticker VXX. Unlike the TVIX, the iPath VXX (NYSEARCA:VXX) is designed to be near the performance of the actual VIX futures. Because futures are the nearest and likely the best way to track the actual CBOE VIX, futures are used to hedge the position and Barclays bank simply takes a management fee cut for its trouble.

While not getting hit over the head as hard as investors of TVIX, investors of VXX are licking their wounds lately too. Shares have dropped from near $30 to under $18 in just a few weeks. Credit default risk, or the perception of the risk is likely a part of the drop as the actual VIX, has not moved in line with the VXX (and of course even much less so relative to TVIX). Because there really isn't much of a tool to arbitrage the move (remember the TVIX has been trading at a premium so the correct arbitrage would be to short TVIX and buy VIX futures) as long as the future premium is uncertain the shares can become misaligned and stay that way for some time. Once fear takes over, it doesn't matter so much as what it is worth next week if in the meantime your portfolio is getting pounded on right now.

Is there a possible trade in all this? I believe so and started trading it myself. I have traded back and forth in the last couple of days - the VXX $18 strike price puts. I shorted two days ago and covered yesterday. Again yesterday I shorted again into the close and will look to either roll downward or add into the last half of trading today. The time decay (theta) is of course very large with VXX right now as premium moves higher. I also sold covered calls with VXX in another account for basically the same trade. The covered calls are slightly better for premium collection, but both are similar and correlated trades.

Can the VXX continue to move lower and maybe even go to zero? Sure, like any stock we don't know what the future holds, but based on history I like selling volatility into panics because it puts the odds into my favor. Selling options lowers the beta of the trade (volatility) and also lowers the overall risk relative to buying the stock outright. Is this a good trade for you? Probably not, unless you are comfortable catching falling knifes and know what you're risks are, this may be a good one to sit out and watch. For those with a thick glove and experience this may be a knife worth grabbing by shorting the volatility.

Regardless if you trade this one or not, both VXX and TVIX should be good to watch next week.

I use a proprietary blend of technical analysis, financial crowd behavior and fundamentals in my short-term trades, and while not totally the same in longer swing trades to investments, the concepts used are similar. You may want to use this article as a starting point of your own research with your financial planner.

Disclosure: I am long VXX.