In my last blog post, I described XMonetae’s investment philosophy in more detail, specifically focusing on our opportunistic modus operandi in the latter half of the post. In this post, I will review a classic opportunistic trade that fit within our market-neutral event-driven wheelhouse and touch upon how an investment process with a systematic foundation is critical to take optimal advantage of such opportunities.

The XIV ETN Blowup

On February 5th 2018, the US stock market experienced a sharp selloff from all-time highs. The VIX Index, which tracks the market’s expectation of volatility over next 30 days, had its largest 1-day gain ever, rallying just over 117%.

This movement in the VIX caused extreme dislocation in certain products designed to track the VIX index; specifically, an exchange-traded note (ETN) with the ticker symbol XIV. It was designed to track the inverse returns (short position) of a basket of VIX futures contracts.

By the close of VIX futures at 16:15 EST (dashed light blue line), the futures basket was trading up over 80%, which by mandate meant the ETN would be liquidated. XIV, however, was only trading down 20%.

Thus, there was a window of time during which you could have shorted XIV at $85-$90 (dark blue line at 16:15 EST) when it was clearly worth near $0. You could have also simultaneously shorted the VIX futures (represented by the VIXY ETN in gray) to hedge directional risk.

This is a great example of what we look for from an opportunistic perspective – as I alluded to in my previous post, this is an event that created a structural liquidity arbitrage. It’s likely that many of the funds that did business in keeping XIV and the VIX futures basket in line were blown out in the move into 16:15 EST (note the gold histograph). XIV started trading at a significant premium; certainly enough of a premium to create significant paper losses for the average quant PM doing that trade, which could then trigger internal fund risk limits, force liquidation, and thus exacerbate that premium.

This is exactly the kind of event-driven trade that should be executed on a discretionary basis. A VIX ETN had never blown up before. There is no model or automated trading algo that is ready (or rather, should be ready) to trade this move given its unique context. Trading such an event should require high-touch, dynamic risk management. We believe this can only be achieved through careful discretion.

Now, if you weren’t actively monitoring all VIX products on that specific day at that specific time, you might have missed this incredible opportunity. So although we believe human discretion is necessary to garner a safe profit from these events, it is clear the machine is much more effective in identifying these uncommon opportunities. This is exactly why we’ve dedicated a significant amount of time and resources into building a proprietary multi-asset-class alerting system that notifies us when markets are dislocated, just like they were during this VIX event. It is here that the systematic part of our investment process comes into play for such event-driven trades.

Stay tuned for another opportunistic trade example in pt. 2.