Daily Recap: Stock Market Collapse Highlights Perils of Shorting Volatility

Anxious traders dumped U.S. stocks on Thursday, as Wall Street’s perilous drop suddenly resumed following two days of calm. The outlook on equities has soured once again, leading many to question whether the so-called Trump reflation trade was fading after more than a year of record-breaking gains.

Stocks Plunge

The dreaded slide that gripped stock markets earlier this week returned on Thursday, as Wall Street’s major averages fell more than 2% apiece. The Dow Jones Industrial Average was off 1,032.89 points at the close, settling at 23,860.46. All 30 index members contributed to the drop.

The broader S&P 500 Index plunged 3.8% to finish at 2,581.00, with all 11 sectors ending negatively. The selloff hit discretionary stocks, industrials, tech and financials the hardest, with each sector falling 2% or more.

Meanwhile, the technology-focused Nasdaq Composite shed 3.9% to close at 6,777.16

Thursday’s closing levels were the lowest in over a month. Stocks have now completely reversed year-to-date gains after being up by at least 5.5% through the first four weeks of 2018.

Products Shorting Volatility on the Verge of Collapse

Implied volatility returned in a big way on Thursday, as the CBOE VIX spiked double digits to return above 30. Wall Street’s preferred fear index rose more than 20% to close at 33.46. As we reported earlier, a Vol reading above 30 is normally associated with recessionary periods for the U.S. economy.

The fear index rose more than 115% at the start of the week in a session now referred to as “Black Monday 2018.” The massive surge all but obliterated short-volatility products, such as the XIV and SVXY.

The VelocityShares XIV exchange-traded note had nearly $1.9 billion in assets on Jan. 31. By the sixth of February, its total assets were a meager $110 million. SVXY courtesy of ProShares shed nearly $1.4 billion in assets over the six days.

XIV trades in the opposite direction of the VXX, a product that longs volatility but decays horribly decays over time. When volatility rises, so does the VXX. This environment leads to a drop in XIV, which trades in the same direction as the S&P 500 Index, only three-to-five times faster.

XIV emerged as a hugely profitable play after Trump took office, returning more than 280% between the presidential election and last month’s peak. After hitting 145 on Jan. 22, the XIV has now dropped nearly 100%. On Thursday, it finished at 5.10, down more than 18% from the previous close.

Rate-Hike Bets Grow

There was no immediate catalyst behind Thursday’s dramatic fall, although it was apparent that large institutional players were deleveraging ahead of anticipated rate hikes. With wage inflation rising, investors are bracing for the Federal Reserve to pursue a faster rate-hike schedule, beginning at the next FOMC meeting in March.

According to CME FedWatch Tool, traders are eyeing a nearly 78% likelihood of higher rates next month.

The Fed predicted in December it would raise interest rates three times this year. Under the guidance of new Chairman Jerome Powell, the central bank could adopt a more transparent method of communicating forward guidance. Powell has already expressed some discontent over the now infamous “dot plot” chart, which conveys policymakers’ anticipated path of interest rates.

The March FOMC policy decision will be accompanied by a revised summary of economic projections covering inflation, GDP and unemployment. Officials will also lay down their latest interest-rate forecast for the next three years.

Featured image courtesy of Shutterstock.

Chief Editor to Hacked.com and Contributor to CCN.com, Sam Bourgi has spent the past nine years focused on economics, markets and cryptocurrencies. His work has been featured in and cited by some of the world's leading newscasts, including Barron's, CBOE and Forbes. Avid crypto watchers and those with a libertarian persuasion can follow him on twitter at @hsbourgi