Yesterday we presented a must-read, if somewhat misleading, Q&A from Goldman’s head quant to the bank’s clients explaining the trading dynamics of ETPs in general, and whether clients have to be worried about another imminent volatility spike and selloff in particular (in response to which Goldman said no, which in light of today’s events may not have been the best advice).
And while we urge readers – especially those who are unfamiliar with the vol products and ETFs – to read the entire article, one particular section is critical, as it explains not only the bizarre marketwide meltups we have observed every day for years, but also why – on some days like Monday – the last minutes of trading are nothing short of total chaos.
Here is Goldman responding to “Why do issuers of VIX ETP have to trade near the 4:15 futures market close?“
The indices behind the VIX ETPs are based on one-day changes in VIX futures levels, measured by their 4:15 PM NY time prices. Every day, an ETP’s NAV change is a weighted average of the one-day returns of two VIX futures, but those weights change every day. It is only at the close of each trading day that the next day’s weights are fully known, because the total dollar amount of futures involved needs to be exactly the right leverage times the price of the product. This process becomes a feedback loop because each ETP’s closing NAV is an input to the size of its position the next trading day. As we approach the close every day, an ETP issuer shifts its portfolio to the next day’s position so it can correctly replicate the next day’s return.
While this is hardly rocket science, it should be clear that any time you see the words “a process becomes a feedback loop” mentioned in the same sentence as the “close of trading”, run.