An Expert's Walkthrough on Exactly How the XIV is Ripping People's Faces Off.

 

originally on marketslant.com

Volatility Bad?

There will be many stories in days to come on how Volatility was the culprit. That will be a lie. Volatility ETFs will be liquidated. Custodians of  "Short Volatility ETFs" like XIV ( VIX backwards, isn't that cute?!) may default.  Volatility is NOT the problem. The people managing risk were the culprits. And those same people are NOT long Gold nor are they storing a portion of your wealth in a much less volatile asset to preserve your buying  power. The December analysis by my sometimes communistic SKG co-writer was spot on - Bon Scott of SKG

Gold Bad?

The Fed's "Normalization" idea is put on hold now. Perhaps interminably. Where does that put the USD longer term? What happens to the greenback after the deluge of debt being issued cannot be offset by higher short term rates for fear of tanking stocks? Gold Goes UP. That's what happens. Just not on our short term ADHD scrolling ticker addled time frames. Permanent monetization of debt is coming- Fay Dress for SKG

The Short Version

There is a lot to read and watch today. We have been using this post - which started as a repost of the answer key to why things are going as they are - as an update section on what we are seeing. 

In the interest of time; Here is a summary of what is going on right now in the volatility sector. We focus on Pensions,but feel free to substitute any sector you want. It's all is applicable. I ask you to bookmark and share this with friends and family who may be saying "Why" and "WTF" right now. What follows is the reason and the classes of people to whom you should be pointing your fingers. Here is a key extract from the original post on December 4th post describing the "how" before the turmoil occurred. This is, as I am fond of saying "The Answer Key" for the what, why, and how of this theft of wealth.

This is the way the next crash will likely come. The need for yield for pension funds to actually pay their retirees makes them prime targets for bank ideas to create yield. Ideas like "just sell vol". And like those old school sellers of strangles to capture premium, they have been right almost 5 years running. But it takes only 1 time to be  wrong, and that pension will blow up.

Simply put, unhedged stock longs will buy puts hand over fist in a washout to hedge their downside. And that will trigger Pension fund losses from short Vol positions against no other asset, or worse, pensions will have to buy stocks at prices above where they are trading.*

 And the more it goes against them, the more they sell. They are betting on a regression to the mean concept with no regard for margin calls or bank roll  management. 

Here is what is scary. Those Pension  managers selling vol are jumping on a band-wagon environment created by the Fed. And, like Portfolio Insurance in 1987, they will sell more as it goes against them. They are doing what is almost exactly like that ill-fated, poorly conceived, no-accounting-for-exit- risk in VAR concept Wall Street sold them that lead to the 1987 crash.

This is written for the general public, so that they may better understand why they will never be permitted to catch up to their bosses in wealth terms. The custodians of their money are mostly idiots. The rich will get richer.

Sincerely,

Vince Lanci - vlanci@echobay.com

 

The Updates

 

Update 2:13pm Pension Managers Aren’t Only Ones to Blame

An email or 2 made comment that it’s hyperbole to lay it all at Pension managers’ feet.

That is true. Here was my reply to those folks

Despite my slightly irresponsible populist tone, it’s a fact that even a responsible PM can’t attain the heights needed to make the unreasonable projections for pensioners. 
They are put in a bad situation. 

This is the heart of what am seeing in CT and IL. Forever extrapolating unreasonable returns..
This is a combination as you eloquently put of: demographics, entitlement mentality, financial engineering covering real growth, and poor expectation management. 

I just wish someone on the risk management side said something to the politicians before it became too late. Even if they had, I do doubt the pols would have listened however. 

It is not unlike the auto unions vs  mgt  issues that contributed greatly to the death of the industry.So yea.  

It is liberalism’s promises run amok. Forever extrapolating unreasonable returns..kicking cans down

roads.  - VBL.

 

UPDATE: 11:04 Everything is NOT fixed

via zerohedge

Just when you thought is was over...

US equity markets are back in the red after the ubiquitous opening ramp and reassurances that all is well...

 

And VIX is spiking back above 45...and notably higher on the day...

 

And as stock sink back so Treasury yields also drop from payrolls resistance...

 

UPDATE  - 10:15 AM Everything is fixed.

 

And Gold?

Gold likely didn't get bought much the past 2 days. It was just ignored. And now it gets smacked after not benefiting from the disaster that is human frailty managing our money. All in all, I would rather have a pet rock making decisions on  my money than those clowns shorting volatility for dividends. It is unthinkable why there are not more people buying Gold now as a hedge against people's subjectivity if not counterparty risk itself. - Soren K.

UPDATE 8:40 AM Feb 6: Everybody is talking about the contribution volatility has and continues to make to the slaughter of the stock market. The XIV being the tip of that spear. The unanswered question for many who can catch their breath is HOW DID THIS COME TO BE?

We now know the means by which the markets have begun their meltdown. What we lack is the motive that triggered this. That motive lies in the greed that preceded the fear we are seeing now.

The Math

Lesson from XIV:

Return profile:
Year 1: 100%
Year 2: 100%
Year3: 100%
Year 4: 100%
Year 5: 100%
Year 6: 100%
Year 7: 100%
Year 8: 100%
Year 9: 100%
Year 10: (100%)

The average return is not 80% (800/10), but 0%

— Anil (@anilvohra69) February 6, 2018

 

UPDATE- 8:00 PM Feb 5th: Given market behavior the last few days and the destruction of short volatility players who actually sold Vol as a dividend for their portfolios; check that- YOUR portfolios if your money is in a pension fund;

We thought it proper to trot out this rather clear explanation and prediction made less than 2 months ago of exactly how the public is getting the shaft this time. And it is happening right now.

That is how people are getting their faces ripped off. Margin calls are coming in. Here is a walkthrough of how greed and Wall Street product enablers combine yet again to destroy your wealth.

 

The Original Post

 

Pensions Strapped for Money to Pay Retiring Boomers are Going to Die as They Hunt for Yield By Shorting Naked Vol.

History does not repeat itself, It does however, hum the same melody

by Vince Lanci

This is the way the next crash will likely come. The need for yield by pension funds to actually pay their retirees makes them prime targets for bank ideas to create yield. Ideas like "just sell vol" are now being lapped up. And like those old school sellers of strangles to capture premium, and the users of "Portfolio Insurance" pre-1987, they have been right along time now. But it takes only 1 time to be wrong, and that pension will blow up. Who is on the other side of those short vol positions we wonder?

 

The 1987 Crash Cause was Portfolio Insurance & (No) Exit Liquidity

The  ludicrous Wall Street  strategy/ idea pitched to investors known as Portfolio Insurance is what caused the 1987 crash. This risk has essentially been recreated from  my point of view in the naked selling of the VIX in  combination with the passivity of investors as exemplified by products like ETFs.

 

The New Crowded Trade

With the need for yield, pension funds are now selling volatility for income. One would think this is not unlike selling covered calls on Gold or a stock you own.  But that is not the case here at all.

What is happening now is fund managers who need to perform for their retiring pensioners are simply shorting volatility as an asset class itself. They are not writing calls against a long stock to create income without adding to downside risk. In fact, many will be forced to buy stocks at higher values than they are trading in a collapse. They are selling PUTS as well as Calls either directly or via the VIX index. Thier risk is volatility added on top of their stock price risk. They are naked short an asset that is essentially a Texas hedge for stock longs.

Caveat: that is not to say the Fed won’t ensure vol stays manageable to keep from collapse. The proceeds  are profits made from vol longs. Buyers are subsidizing pensions. Remember, the Fed can stay irrational longer than you can stay solvent. And when it comes down to it, pot odds may dictate actions in the future. So while I outline the recipe for disaster below, even the best risk reward scenarios don’t pay off sometimes. Just saying.

How 1987 Happened

Back then, stock holders were told  to sell indices if their particular stock  went down. How it likely went down as a broker advises his client who is long IBM:

Market lower?... sell stock index futures... If it goes lower, sell more. IBM is great. it is the broader market we have to be careful of dragging IBM  down unfairly.

This created a self reinforcing cycle as arbitrageurs sold shares while long stock holders sold futures to hedge their position.

 

Fundamentals Did Not Matter in 1987 And They Don’t Now

You see, these people believed the stocks in their portfolio were GOOD. The advice given by Wall street at the  time was to NOT sell your longs as they were good. But rather sell broad indices to hedge your market risk. This was before the ability to buy put was facile The killer is, these people were told  to sell into weakness, not to put on  a hedged position at the beginning. It was insane. This was a product/ idea created by Wall street firms to generate commissions with no regard to exit liquidity. It was a crowded trade.

The same thing is happening again. Pension funds are betting on the Fed to give them the "put" back. The much used metaphor of the "Fed Put" is now being assumed to be  real. to repeat: They are not short options against an asset. And the more Vol goes against them, the more they sell. They are betting on a regression to the mean concept with no regard for margin calls or bank roll management. 

 

How It Will [edit: IS ] Happen(ning) Again

Pension funds selling Vol, like Portfolio insurers before them, are going to be forced to play the martingale roulette wheel approach to investing. The further your position goes against you, the more you sell stock indices to hedge your particular stock. Double down until you make your money back and no "0" or "00" please.

GOLD EXAMPLE:Stock holders were actually told to sell their Gold instead of selling their stock losers. If you are old enough, Gold was called limit up in 1987, and ended limit down form  stock longs selling to maintain their stock positions.

 

The New Crowded Trade is Short Vol

Volatility of an asset is not risk per-se. Bank roll management, length of time a  position is held and other factors reduce it to noise if properly managed. But what if Volatility of stocks is the asset being shorted itself as some sort of income stream for a stock portfolio?  Not  just Calls, but Puts as well. The major component (Volatility / Time  value) of the very instrument (Puts) used to hedge directional stock risk is being shorted as well now. The more premium collected the better. 

Further, In a declining stock market, Volatility will move consistently with the dominant players position. These are stock longs we speak of as "dominant". The "tell" of who has the biggest risk is in  the volatility smile's skew. That skew tells me and every other option guy that stock longs are the dominant (not necessarily the strongest) players.

Skipping a few steps; in the stock market, lower prices cause an increase in implied volatility due to an inverted correlation and the stochastic  nature of volatility. Simply put, unhedged stock longs will buy puts hand over fist in a washout to hedge their downside. And that will trigger Pension fund losses from short Vol positions against no other asset, or worse, pensions will have to buy stocks at prices above where they are trading.*

 And the more it goes against them, the more they sell. They are betting on a regression to the mean concept with no regard for margin calls or bank roll  management. 

Here is what is scary. Those Pension  managers selling vol are jumping on a band-wagon environment created by the Fed. And, like Portfolio Insurance, they will sell more as it goes against them. They are doing what is almost exactly like that ill-fated, poorly conceived, no-accounting-for-exit- risk in VAR concept Wall Street sold them that lead to the 1987 crash.

This is the way the next crash will likely come. The need for yield for pension funds to actually pay their retirees makes them prime targets for bank ideas to create yield. Ideas like "just sell vol". And like those old school sellers of strangles to capture premium, they have been right almost 5 years running. But it takes only 1 time to be  wrong, and that pension will blow up. Guess who is on the other side of those short vol positions.

We bet one pension fund (preferably a union one to really misdirect the public)will be permitted to fail a la Lehman. Then the fed will down something about the problem. 

Appendix

**Option Wonk Note: The Skew of an option smile on an asset  is positively correlated with the stochastic process of volatility in that market. Volatility will move  with the asset price itself. in stocks where skew is to the puts, vol generally decreases in  a rally, and increases in a sell-off ( provided the Fed isn't keeping a lid on it).

 

Good Luck 

Vince Lanci

Vince Lanci has 27 years’ experience trading Commodity Derivatives. Retired from active trading in 2008, Vince now manages personal investments through his Echobay entity. He advises natural resource firms on market risk. Over the years, his expertise and testimony have been requested in energy, precious metals, and derivative fraud cases. Lanci is known for his passion in identifying unfairness in market structure and uneven playing fields. He is a frequent contributor to Zerohedge and Marketslant on such topics. Vince contributes to Bloomberg and Reuters finance articles as well. He continues to lead the Soren K. Group of writers on Marketslant.