Options on Leveraged Vix Etfs – Legal Issues

Don’t touch the Vix! Oops.

This article is a follow-up of the “Don’t Touch the VIX! Oops” article, published in March 2018, available
at this link. Here are the main ideas it developed:
• The VIX is an implied volatility index. The dynamics and properties of volatilities are significantly
different from those of a regular stock/index, a currency or a bond.
• Moreover, the complicated VIX formula makes it improper for replication, forcing investors to
trade futures and options to gain exposure, with a significant liquidity downgrade to standard
indices.
• While quantitative strategies offer better risk-adjusted performance than discretionary
investments, the young age and lack of experience of the strategists used to produce this research
at large banks generate an experience short-fall. Cost-cutting increases the probabilities of bad
investment recommendations.
• Large broker-dealers already have the capacity to trade quantitative strategies, but they have lost
the right and the capital to trade them on a proprietary basis due to the change in regulations and
capital requirements. Meanwhile, there is a strong commercial and economic need to provide
new structured products with differentiation and investment content. As a result,
quantitative/proprietary strategies have been distributed to clients after packaging in structured
products.
• As institutional margins are compressing, the target of structured product distribution is moving
away from institutionals & corporates towards UHNW and retail.
• Volatilities have gone down over the last decade and the ‘short vol’ strategy has been profitable
for most of the years since the credit crash. Other volatility strategies have done well too.
‘Volatility as an asset class’ has becomes the new paradigm, and volatility derivatives are
distributed to retail, despite the technicity required for option trading. There is a whole cottage
industry around such products.
• Benchmark manipulations are easy and frequent. Like any other index, the VIX can be
manipulated and probably is. See the academic article of Griffin & Sham, which offers solid
arguments.
• It’s not easy to construct bear instruments. Current reverse ETFs are the best approach, but they
have drawbacks. They notably need daily re-hedging, for which issuers need to trade twice the
variation of their hedging notional. Furthermore, issuers have to buy more of the underlying when
it goes up. In case of a a significant move up, issuers will have to buy a large quantity of hedge.
On a side note, they have a performance drift detrimental to long-term investors.
• XIV and SVXY are bear notes on the VIX. They have been pushed to retail as part of the answer for
quant retailing trends. The issuers nevertheless added some surprisingly solid disclaimers on their
prospectus. They actually stated that these products were bound for failure.
• Like all reverse ETFs, the XIV and SVXY need daily re-hedging on the close. The important S&P and
VIX move on February 5th, 2018, meant that issuers had a large notional to buy, too large for the
liquidity of the futures market. A liquidity crunch resulted. During the stampede, the two reverse
ETFs lost ~90% of their value in the space of a few hours.
• Retailing such structures was probably not the greatest idea.
• Since it is very likely that VIX expiries have been manipulated and that poor products have been
pushed to a mass audience of retail investors, a significant legal/regulatory blowback can be
expected.

The VIX gaps up

If you had any doubts about the atypical nature of VIX, just look at these two graphs. McDonald, a typical
stock, is on top. On the bottom is the VIX:

A stock trends up over time, close to an exponential function. The VIX goes sideways, aka mean-reverts.
But its evolution around the mean is not a simple oscillation; it gaps up before decaying exponentially, a
process which seems to be happening at multiple timescales. There is a ‘physical’ explanation to this
behavior. When bad news frighten the market, option prices are immediately impacted, while it takes
much longer for the market to reassure itself and cool down. This process is occurring at random times,
with random amplitudes, generating this gap-up-and-decay behavior visible at multiple time frequencies.

A more heuristic analysis would indicate a significant tail to the right for the VIX – the index has many
more positive moves than ‘normal’ [source]:
This deviation from the standard normality is easier to see on the Q-Q plot of the returns (probability of
event actually happening vs ‘Normal’ likelihood of event). The blue curves of the VIX is well above the
‘normal’ red line for large positive moves, emphasizing the high incidence of significant upward moves
[source]:

Options on VIX are highly exotics

The dynamic of the VIX, the stochastic model describing its evolution over time, is very different from a
regular asset. It is also intertwined with that of the S&P 500. It took a solid decade of research to properly
model that dual behavior.
A few academic papers are referenced below. If you like tough math, these will make your day.

• https: / /pdfs . semanticscholar . org/d521/6b6295e24cd620405beae0036660fa85f1e7.pdf

• https: // pdfs . semanticscholar . org/31ac/257c05bd370a959af21f1823b81836aad1ab.pdf

• https: // www2 . math . su . se/matstat/reports/master/2014/rep2/report.pdf

• http: // www . math . columbia . edu/~mnutz/docs/VIXFutures.pdf

• http: // faculty . baruch . cuny . edu/jgatheral/Bachelier2008.pdf

The root cause of these behaviors and the solid research papers needed explaining them is that the VIX is
not a physical asset, but a volatility. As a consequence, VIX options actually belong to the category of
derivatives called ‘options on options’ or ‘vol-on-vol’ products. Vol-on-vols are considered extremely
complicated derivatives, ‘highly exotic’ in trader’s linguo. Only the most advanced institutional brokerdealers started trading them initially, and with many risk restrictions.

There is no doubt that vol-on-vols are inadequate for amateur traders and speculators, as a layman has
virtually no chance of understanding their risks or know their appropriate handling requirements. Worse,
vol-on-vol productsseem to behave like regular options, bringing a false sense of security, until they don’t.
Not only those atypical movements are then large and painful, but those ‘cardiac events’ are far from
rare.

Options on leveraged VIX ETFs are worse

Adding another layer of complexity between the VIX index and its options won’t make the math easier,
even if there are caveats indicating that the diffusions models are somewhat similar. This article will not
add insult to injury by showing even more complicated research papers. Instead, this note looks at some
of the legal issues associated with options on leveraged VIX ETFs.

Here is an extract of the first page of the XIV prospectus (underlines are mine, but bolds are in the text):
The ETNs, and in particular the 2x Long ETNs, are intended to be trading tools for
sophisticated investors to manage daily trading risks. They are designed to achieve
their stated investment objectives on a daily basis, but their performance over
longer periods of time can differ significantly from their stated daily objectives. The
ETNs are riskier than securities that have intermediate or long-term investment
objectives, and may not be suitable for investors who plan to hold them for longer
than one day. Accordingly, the ETNs should be purchased only by knowledgeable
investors who understand the potential consequences of investing in volatility
indices and of seeking inverse or leveraged investment results, as applicable.
Investors should actively and frequently monitor their investments in the ETNs,
even intra-day.

In plain language: these ETFs are dangerous. The ETFs should not be held for more than one day.

The Risk Factors section even includes this nugget (bold and underlines are in the text):
The long term expected value of your ETNs is zero. If you hold your ETNs as a long term
investment, it is likely that you will lose all or a substantial portion of your investment.
But who reads SEC-required prospectus these days? Certainly not the average investor, even if he should.
Professionals are expected to do it, but they usually know enough about the products and have enough
good sense to only verify when a potential issue may arise. Most importantly, they have the experience
to size their risks according to the limits of their knowledge.

But there are subsequent legal issues, which deserve to be asked:

• The CBOE, a self-regulatory and for-profit entity, is the ultimate market professional. It pays
quants to research complicated option VIX models, lawyers to read prospectus and compliance
officers to issue and enforce regulations. Like all exchanges, it creates products and rules, so that
people can discover their price and trade them. Does it remain appropriate that the CBOE creates
options on a reverse VIX ETF and distribute it to all investors, including retail, considering all the
issues above?

• Why can a call option – aka a long-dated investment product – be created on a security, whose
issuer specifically states it should not be held for more than one day?

• How can a broker-dealer treat such derivatives like any other option, letting retail clients gain
access to them without additional precautions? Shouldn’t there be some additional suitability
and/or training requirements?

• How can a broker dealer authorize such products to be traded on margin? Why are broker-dealers
not differentiating the margin requirements?

Margin regulations

I will let attorneys handle the CBOE question. There are enough class actions in the work for legal teams
to assess the duties and liabilities of an exchange on such a matter.

But I will mention that FINRA, the issuer of the margin requirements, does not differentiate a reverse ETF
from a stock, nor does it differentiate the VIX from ‘broad-based indices’ (already at a lower margin
requirement than stocks). This being said, it requires its members to (my underlines):

4210 (d) Additional Margin
Procedures shall be established by members to:

(1) review limits and types of credit extended to all customers;

(2) formulate their own margin requirements; and

(3) review the need for instituting higher margin requirements, mark-to-markets and
collateral deposits than are required by this Rule for individual securities or customer
accounts.

4210 (f) Other Provisions

(1) Determination of Value for Margin Purposes

Active securities dealt in on a national securities exchange shall, for margin purposes, be
valued at current market prices provided that, only those options contracts on a stock or
stock index, or a stock index warrant, having an expiration that exceeds nine months and
that are listed or OTC (as defined in this Rule), may be deemed to have market value for
the purposes of this Rule. Other securities shall be valued conservatively in view of current
market prices and the amount that might be realized upon liquidation. Substantial
additional margin must be required in all cases where the securities carried in “long” or
“short” positions are subject to unusually rapid or violent changes in value, or do not have
an active market on a national securities exchange, or where the amount carried is such that
the position(s) cannot be liquidated promptly.

/01 Concentration or Volatile Securities

Substantial additional margin must be required:

• When there are concentrations in single securities (either in particular accounts
or in all margin accounts carried) which, due to their size, may not be liquidated
promptly; and

• For accounts with positions in volatile securities subject to unusually rapid or
violent changes in value.

Broker-dealers must request the minimum margin required by FINRA and the onus is on them to impose
further margin when the underlying is ‘volatile or violent’.

• For the VIX, with a large tail risk and where options are highly exotic, good sense would
indicate that they should differentiate VIX options from ‘regular broad-based indices’ and
require this additional margin.

• For reverse VIX ETNs, which have catastrophic events each time the VIX gaps up (a frequent
occurrence), which are said to be dangerous by its issuers, which are unsuitable for long-term
investments, and whose options are even-higher-order exotics, there is an even more clear
need for additional margins, if not training requirements or trading restrictions.

It is hard to imagine than an individual can sell naked puts on XIV and simply add 20% of the ETF as margin
to the premium, when it is known that a reverse ETF can lose 90% of its value overnight. It is nevertheless
the general case, and many retail investors have now lost their shirts and their homes on February 5th as
a result.

The VIX is not a regular asset, due to its abnormal dynamics and its tendency to large upward movements.
Its options are highly exotics and prone to sudden changes in values. Reverse ETFs are described as
dangerous and worthless in the long-term. As the VIX index regularly gaps up, reverse ETFs are obliterated
at regular intervals. If these reverse VIX ETFs are bound for these large and instant losses, Puts on reverse
VIX ETFs are ticking bombs. Selling such puts is the option equivalent of Russian roulette or ‘passing the
grenade’.

Nevertheless, neither the CBOE nor the broker dealers require additional margins for these products,
despite legal obligations from FINRA, nor do they ask for specific warning/training/requirement. There is
therefore an argument to be made that these entities bear some responsibility in investors’ losses.

Order of magnitude of the hidden losses/claims

Notionals of options are usually much larger than the market capitalizations of their underlyings. So, the
financial scale of the losses associated with the options on the VIX and the reverse VIX ETFs is much larger
than the losses seen on the reverse ETFs themselves on February 5th

. There were $800m of XIV traded after hours on February 5th
. Since the reverse VIX ETFs went almost to zero, almost all that amount is
subject to litigation, a staggering number already.

But option notionals are not losses, or are they?

• As the ETFs almost went to zero, the final intrinsic values of the puts have become equal to their
strike price. The losses generated by the move on February 5th is therefore the notional of the
puts, at least for the out-of-the-money options (it is rare to trade deep ITM puts due to their
funding costs so their volumes are probably much lower). In other words, the entire notional of
reverse VIX ETF put options pre-event could be someone’s loss / litigation claim.

• As the calls ended worthless on the other hand, the losses due to the move is actually their
premium. The premium of the calls is an indication of the losses and the litigation claims.

• For the leveraged ETFs (2x, 3x), which have gapped up that day, the puts have ended worthless.
For the call, it’s the notional which is an indication of the losses. So we should consider the put
premium and the call notionals for the long leveraged ETFs as a measure of overall losses/claims.

• Luckily, not all options are held separated from any other; most portfolios contain several puts
and calls at the same time, both long and short. As this cross-exposure reduces the risks and the
changes/losses due to the move, only the order of magnitude of put/call notionals/premium are
the indication of hidden losses and claims.

But if we include options on the VIX index to the options on leveraged VIX ETFs and remember that the
VIX and its derivatives represent more than a third of the CBOE’s revenues, the hidden losses and potential
claims can be quite substantial…

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ABOUT THE AUTHOR: Gontran de Quillacq
Gontran de Quillacq has over 25 years of securities experience specializing in portfolio
management, derivatives trading, proprietary trading, structured products and investment
research. He has worked with top-tier banks and hedge funds in both London and New York.

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Disclaimer: While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer.For specific technical or legal advice on the information provided and related topics, please contact the author.