The stock market as measured by the Dow Jones Industrial Average fell
1,175 points on Monday, 5 Feb 2018. That was the largest one-day point drop in history.
Still, the decline was relatively tame when measured in percentage terms. The Dow Jones fell 4.6% on the day, a significant loss, but far from the 22% one-day drop on Oct. 19, 1987, and the 24% two-day drop on Oct. 28-29, 1929.
Monday was a bad day for stock investors, but the market bounced back on Tuesday to some extent. It was not the end of the world.
Yet, investors should not take too much comfort from the single-digit percentage drop on Monday and the bounce-back on Tuesday. Markets came much closer to a catastrophic meltdown than many investors realize.
The reason for the near catastrophe was the same as the reason for actual catastrophic losses in 1987, 1998 and 2008 – derivatives, leverage and opaque financial structures.
While stocks were down 4.6% on Monday, the leading measure of volatility, the CBOE Volatility Index (VIX) rose 116% on the trading day. And, an even more obscure exchange traded note (ETN) called the “Daily Inverse Vix” (XIV) fell almost 80% in the two hours after trading ended.
VIX does not necessarily trade in a linear way relative to underlying stocks. While stocks fell 4.6% on Monday, VIX rose 116%. This was indicative of the fact that traders see the stock market fall as the end of an extraordinarily long period of low volatility.
The VIX was trading on an historically low baseline. The rise in VIX reflected not only Monday’s volatility, but also an expectation that higher volatility is here to stay at least for a while.
XIV is an even stranger animal. It is a note that pays the holder a return based on the inverse of VIX. If VIX drops, the XIV note holder earns a higher return. If VIX rises, the XIV note holder suffers a loss. That much is clear. What is not as clear is why a 116% rise in VIX led to an 80% drop in XIV.
Still, the decline was relatively tame when measured in percentage terms. The Dow Jones fell 4.6% on the day, a significant loss, but far from the 22% one-day drop on Oct. 19, 1987, and the 24% two-day drop on Oct. 28-29, 1929.
Monday was a bad day for stock investors, but the market bounced back on Tuesday to some extent. It was not the end of the world.
Yet, investors should not take too much comfort from the single-digit percentage drop on Monday and the bounce-back on Tuesday. Markets came much closer to a catastrophic meltdown than many investors realize.
The reason for the near catastrophe was the same as the reason for actual catastrophic losses in 1987, 1998 and 2008 – derivatives, leverage and opaque financial structures.
While stocks were down 4.6% on Monday, the leading measure of volatility, the CBOE Volatility Index (VIX) rose 116% on the trading day. And, an even more obscure exchange traded note (ETN) called the “Daily Inverse Vix” (XIV) fell almost 80% in the two hours after trading ended.
VIX does not necessarily trade in a linear way relative to underlying stocks. While stocks fell 4.6% on Monday, VIX rose 116%. This was indicative of the fact that traders see the stock market fall as the end of an extraordinarily long period of low volatility.
The VIX was trading on an historically low baseline. The rise in VIX reflected not only Monday’s volatility, but also an expectation that higher volatility is here to stay at least for a while.
XIV is an even stranger animal. It is a note that pays the holder a return based on the inverse of VIX. If VIX drops, the XIV note holder earns a higher return. If VIX rises, the XIV note holder suffers a loss. That much is clear. What is not as clear is why a 116% rise in VIX led to an 80% drop in XIV.
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