Friday, June 22, 2018

$4.3 Million Bender v UBS of Puerto Rico Award

In June 2018, a FINRA arbitration panel in San Juan, PR ordered UBS Financial Services and UBS Financial Services of Puerto Rico to pay $4,20,000.00 in compensatory damages, plus costs of $100,000. You can read the award here. Dr. McCann testified on liability and damages over UBS Puerto Rico's sale of Puerto Rico municipal bonds.

Thursday, March 29, 2018

$1.9 Million Medero-Fernandez v UBS of Puerto Rico Award

In March 2018, a FINRA arbitration panel in San Juan, PR ordered UBS Financial Services and UBS Financial Services of Puerto Rico to pay $1,880,000.00 in compensatory damages. You can read the award here. Dr. McCann testified on liability and damages over UBS Puerto Rico's sale of UBS Puerto Rico municipal closed end bond funds.

Monday, March 12, 2018

Material Misrepresentations in XIV's Prospectus Led to $700 Million in Losses

By Craig McCann, Regina Meng,  Edward O'Neal and  Mike Yan

A PDF copy of this post for you to email or print is available by clicking here.

Executive Summary

Credit Suisse’s XIV Exchange Traded Note (ETN) linked to the inverse of short-term VIX futures prices lost 97% of its value or approximately $2 billion in a single day on February 5, 2018. Credit Suisse announced the following morning that it would redeem all outstanding XIV shares at the Closing Indicative Value on February 15, 2018.1

Figure 1 reports the daily closing price for XIV from its inception in November 2010 to its demise in February 2018. The run-up in 2017 corresponds to a lengthy period of low stock market volatility.


Figure 1

Credit Suisse’s latest Pricing Supplement for the XIV can be accessed by clicking here. Credit Suisse represented in the Pricing Supplement that it would publish an estimate of the current economic value of XIV shares every 15 seconds based on real time VIX futures prices but, in fact, did not. On February 5, 2018 the difference between what Credit Suisse said it would do and what is actually did was enormous because Credit Suisse effectively stopped updating its estimate of the current economic value of XIV shares at 4:10 pm when VIX futures prices were changing significantly.

From 4:10 pm to 5:09 pm on February 5, 2018 Credit Suisse was materially misrepresenting the true economic value of XIV.  Investors were buying XIV between 4:15 pm and 5:08 pm at prices as high as in the $80s when Credit Suisse was representing to the public that the economic value of the notes was $24.6961 but had to know that the true economic value was aready between $4.22 and $4.40.

By 4:13 pm or shortly thereafter sophisticated market participants would know that Credit Suisse was certain to redeem XIV for $4.22 or a little more per share. Investors paid $823.6 million to purchase 28.8 million shares after 4:15 pm at an average price of $28.60. Those aftermarket purchases at inflated prices transferred $700 million from unsophisticated, poorly-informed buyers to sophisticated, well-informed sellers.

In addition to the problem with Credit Suisse’s Pricing Supplement prospectus we identify, we find that extraordinary trading in two critical futures contracts in the last minutes of trading before 4:15 pm on February 5, 2018 pushed up the futures’ prices and triggered the XIV liquidation. The primary beneficiaries of this manufactured liquidation of XIV are Credit Suisse and the traders who had previously sold XIV short.

The problems we identify herein are not unique to XIV but are found in other ETNs tied to the S&P VIX futures indices.

Intraday Indicative Value and Closing Indicative Value

XIV trades at prices that are determined by supply and demand just like other exchange-traded securities.  However, Credit Suisse also calculates and publishes an estimate of the value of XIV called the “Intraday Indicative Value” throughout the day and once a day a “Closing Indicative Value”.2

On page 5, XIV’s Pricing Supplement states “The “Intraday Indicative Value” for each series of ETNs is designed to approximate the economic value of such series of ETNs at a given time.… the calculation is based on the most recent intraday level of such Index at the particular time. The Intraday Indicative Value of the ETNs will be calculated every 15 seconds …”

On page PS-30, the Pricing Supplement says “The value of each [S&P VIX futures] Index will be published by Bloomberg in real time and after the close of trading on each Index Business Day under the following ticker symbols: …” and “The intraday level of each of the Indices is calculated in real time by S&P … applying real time prices of the relevant VIX futures contracts.”

Credit Suisse’s representations in the Pricing Supplement that the Intraday Indicative Value 1) approximates the economic value of the ETNs, 2) is updated every 15 seconds based on the most recent levels of the Indices which are 3) calculated by S&P in real time from 4) real time prices of VIX futures contracts were false.

Credit Suisse was using a Standard & Poor's Index it knew or should have known was not being updated every 15 seconds “applying real-time prices of the relevant VIX futures contracts.”

Credit Suisse’s misrepresentations are not trivial. The XIV Pricing Supplement includes the following:
… Paying a premium purchase price over the Indicative Value of the ETNs could lead to significant losses in the event the investor sells such ETNs at a time when such premium is no longer present in the market place or such ETNs are accelerated (including at our option, which we have the discretion to do at any time), in which case investors will receive a cash payment in an amount equal to the Closing Indicative Value on the Accelerated Valuation Date (each as defined herein). Investors should consult their financial advisors before purchasing or selling the ETNs, especially for ETNs trading at a premium over their indicative value. …[January 29, 2018 Pricing Supplement, p.2]

Figure 2

Credit Suisse also describes potential early redemption of XIV if the daily Indicative Value decline exceeds 80%:
… If the price of the underlying futures contracts increases by more than 80% in a day, it is extremely likely that the Inverse ETNs will depreciate to an Intraday Indicative Value or Closing Indicative Value equal to or less than 20% of the prior day’s Closing Indicative Value and will be subject to acceleration if we choose to exercise our right to effect an Event Acceleration of the ETNs. …[January 29, 2018 Pricing Supplement, PS-28; emphasis added]
This excerpt from the Pricing Supplement demonstrates that Credit Suisse knew, independent of any calculation by Standard and Poor’s, that an 80% or slightly greater increase in the price of the February and March VIX futures contracts would cause the Indicative Value to breach the threshold which would give Credit Suisse the option to redeem all XIV shares.3

VIX Futures Prices Up 96% by 4:15 PM, Ensured Credit Suisse Would Liquidate XIV

XIV’s Closing Indicative Value is found by applying the negative % change in the closing VIX futures’ settlement values from the previous days’ VIX futures’ settlement values (with a minor adjustment for fees and interest) to the previous day’s Closing Indicative Value. The VIX futures’ settlement values are calculated by the CBOE as an average of the inside bid and ask quotes for each futures contract at 4:15 pm. The difference between the VIX futures’ settlement values and the most recent futures trade prices at 4:15 pm is de minimis because bid-ask spreads are small in near-to-expiration VIX futures contracts. Thus, even if bid and ask quotes for VIX futures contracts were not observable in real time – they are – VIX futures trade prices at 4:15 pm are an excellent indicator of the VIX futures settlement values.

Table 1 

The last trade by 4:15 pm on February 5, 2018 in the February contract was at $33.20 and the last trade in the March contract was at $27.95. These prices were 112.5% and 86.8% higher than the previous day’s settlement values for the February and March contracts. The weights to be applied on February 5, 2018 to these two daily changes were known to be 0.35 and 0.65 so the weighted average increase in the relevant futures settlement values was certain to be 95.77% give or take a trivial amount as a result of using the average of bid and ask quotes at 4:15 pm instead of last trade prices and because of the very tiny daily accrual of interest and fees. See Table 1.

It was thus known to Credit Suisse and other sophisticated market participants by 4:15 pm that XIV’s Closing Indicative Value would decline by 96% from the previous day’s Closing Indicative Value and that Credit Suisse would redeem the notes for pennies on the dollar.

Investors paid approximately $823 million at an average price of $28.60 after 4:15pm when the true Indicative Value was between $4.2217 (Credit Suisse’s revised calculation) and $4.4064 (our calculation as of 4:15pm) although Credit Suisse was reporting the Indicative Value as approximately $24.8933 until 5:08 pm. Credit Suisse knew or should have known that these unfortunate purchasers were certain – not just likely, certain – to lose virtually everything they were paying the instant they were buying the securities.

If the true Indicative Value, updated every 15 seconds based on the most recent Index levels calculated from real time futures prices as represented by Credit Suisse in XIV Pricing Supplement, at 4:15 pm was $24.8933 XIV would not have been liquidated because that would have only been a 77% decline from the previous day’s Closing Indicative Value. The February and March VIX futures prices have declined since February 5, 2018 and so XIV shares would have increased in value if XIV had survived the events of February 5, 2018. In that case, they would be worth approximately $30.88 as of March 6, 2018. Instead, Credit Suisse paid investors $5.99 per share based on XIV’s Closing Indicative Value on February 15, 2018.4

XIV Indicative Value Did Not Track Relevant VIX Futures Prices in Real Time Table 2 lists the spot VIX, the February and March VIX futures trade prices, the S&P Index (SPVXSPID) Credit Suisse used to calculated XIV’s Indicative Value and XIV’s Indicative Value. The first row in Table 2 labeled “February 2, 2018” contains the closing values for the VIX, settlement values for the February and March VIX futures contracts and a weighted-average of those two futures contracts’ settlement values and Credit Suisse’s Closing Indicative Value on February 2, 2018. The rest of the rows in Table 2 summarize our recreation of XIV’s Indicative Value from 4:00 pm to 5:11 pm.

The Last February Futures Trade is the most recent trade price each second. For example, there was a February futures trade at $23.10 and a March futures trade at $18.90, both at 3:59:59 pm. S&P’s Short-term VIX Futures Index assigned a .35 weight to the February contract and a 0.65 weight to the March contract on February 5, 2018 because 65% of the current roll period had elapsed. Applying those weights to the last trade price each second, we derive a weighted average futures price; $20.37 at 4:00 pm.

Credit Suisse reported the same $27.0855 Intraday Indicative Value at 4:10, 4:11 and 4:12 pm. There were significant changes in the real-time prices of the relevant futures contracts and so it is clear Credit Suisse was not updating the Intraday Indicative Value every 15 seconds, based on an Index which was being recalculated in real-time based on the most recent trade prices in therelevant futures contracts.

Credit Suisse did not report the Closing Indicative Value of XIV until 5:09:05 pm on February 5, 2018, 7 seconds after S&P set the daily close level of SPVXSP which XIV tracks at 5:08:58 pm. The Intraday Indicative Value dropped from $24.6961 to the Closing Indicative Value of $4.2217 at the same time, i.e. 5:09:05 pm.

Credit Suisse reported the $24.6961 Indicative Value until 5:08 pm despite the fact that futures trades at 4:15 pm support a $4.40 Intraday Indicative Value and futures quotes support a Closing Indicative Value of $4.22. Credit Suisse was posting Intraday Indicative Values but they were not based on indices “calculated in real time by S&P … applying real-time prices of the relevant VIX futures contracts” as Credit Suisse represented in XIV’s Pricing Supplement.

Table 2 

By 4:10 pm XIV’s True Intraday Indicative Value Had Declined More Than 80%

At 4:10, 4:11 and 4:12 pm, we estimate the Intraday Indicative Value to be $21.8523, $2.2146 and $18.9655. Such low Intraday Indicative Values and the true Intraday Indicative Values at 4:12, 4:13, 4:14 and 4:15 pm as well would have triggered an unwind of XIV if they had been the Closing Indicative Value that day since they are all more than 80% less than the previous days’ $108.3681 Closing Indicative Value.

Our recreated Intraday Indicative Value matches Credit Suisse’s Intraday Indicative Value closely throughout the day but at 4:09 pm Credit Suisse’s reported Intraday Indicative Value began to deviate significantly from the true Indicative Value which might have put investors on notice that XIV was failing. Figure 3 plots XIV bid and ask quotes with Credit Suisse’s reported Intraday Indicative Values and corrected Intraday Indicative Values based on the latest trade prices in the relevant futures contracts.

Figure 3 

Late VIX Futures Trades Appear to Have Intentionally Triggered XIV Unwind

The spot VIX in Table 2 was 90% higher at 4:00 pm on February 5, 2018 than it had closed the previous day. Consistent with the general observations that VIX futures prices move with the spot VIX but with less dramatic swings, the weighted average last futures trade price at 4:00 pm had increased 34% from the previous day’s closing average futures trade price. Between 4:00 pm and 4:15 pm something extraordinary happened; the spot VIX increased 13% but the weighted average futures price increased 46% or 3.5 times as much as the increase in the VIX and 8 or 10 times as much as we would have expected given the 13% increase in the VIX.

Heavy trading in the February and March VIX futures contracts in the last few minutes before 4:15 pm drove their prices up and beyond the threshold at which XIV would be liquidated. Figure 4 plots the % increase in the weighted average VIX futures trade prices from their previous day’s closing levels and the 80% level at which Credit Suisse would be entitled to liquidate XIV. The average futures price had increased from the previous close only 34.5% by 4:00 pm on February 5, 2018. By 4:09:44 pm average futures price had increased from the previous close by over 80%. In fact, it appears that the Intraday Indicative Value hit $0 at 4:10:56 pm.

It is unlikely that the heavy VIX futures trading shortly before the setting of the VIX futures settlement value at 4:15 pm resulted from benign hedging activity by Credit Suisse. Credit Suisse could alter its hedging position well before or after the critical 4:15 pm marker and not impact the likelihood XIV would be unwound and the price Credit Suisse would pay investors for the outstanding notes.

The extraordinary increase in the February and March VIX futures prices late on February 5, 2018 did not result from manipulation of the spot VIX calculation by placement of quotes or trades in deep out of the money put options on the S&P 500. There has been some evidence of manipulation of the VIX for a few seconds surrounding the fixing of VIX levels for settling futures and options.5 There were no VIX futures settling on February 5, 2018. The increase in VIX was large and not fleeting. The increase in futures prices in the last few minutes preceding 4:15 pm was far greater than the increase in the VIX. Other than provoking a liquidation of XIV the potential payoffs to VIX manipulation was no higher on February 5, 2018 than on other days and much less than on days when VIX futures and options settle.

Futures prices change substantially less than one-for-one with changes in the spot price so it would be nearly impossible to move the VIX futures price by manipulating quotes on S&P 500 options. Direct purchases of the February and March VIX futures by Credit Suisse or Barclays or some large investors with short XIV positions account for VIX futures prices increasing much more dramatically than spot VIX levels in the last few minutes before 4:15 pm. XIV had a contingent settlement triggered if the February and March futures prices could be held 80% above their February 2, 2018 settlement values. It appears someone who would benefit from XIV being liquidated on February 5, 2018 was in the market heavily buying February and March contracts between 4:10 and 4:15 pm.

Barclays Has the Same Problem with VXX

We have focused on Credit Suisse’s misrepresentations and conduct because of the dramatic and permanent losses suffered by investors in XIV on February 5, 2018 but the issue we identify is more widespread. Barclays Prospectus for its VXX ETN (available here) makes similar false statements about how the Indicative Value is calculated.

Page PS-3 of the current VXX Prospectus states “First, intraday indicative value is based on the most recent Index level published by the index sponsor, which reflects the recent reported sales prices for the Index components, …” is materially false. The VXX intraday indicative value is not based on an index that reflects the most recent sales prices for the futures contracts included in the index construction.

Also, Barclays conduct on February 5, 2018 was similar only not as consequential as Credit Suisse’s conduct. Barclays published an indicative value of $59.0679 from 4:14 pm until 4:36 pm and of between $58.7892 and $59.1272 until 5:10 pm on February 5, 2018 when it abruptly increased it to $65.4354. The true VXX indicative value at 4:15 pm was approximately $65.38. Investors bought over $500 million of VXX shares between 4:15 pm and 5:10 pm when Barclays updated the Indicative Value to something approximately correct on February 5, 2018.

Tuesday, February 27, 2018

Investors “Strangled” by LJM Preservation and Growth Fund (LJMIX)

By Craig McCann, Edward O'Neal and Mike Yan
A PDF copy of this post for you to email or print is available by clicking here.

The stock market began the month of February on a roller-coaster. During the 6 trading days from Friday, February 2nd to Friday, February 9th, the Dow Jones Industrials had intraday swings of at least 330 points each day. On four of those six days the Dow incurred 1,000 point swings.

Amidst the dramatic market swings two weeks ago, the LJM Preservation and Growth Fund stands out. The Fund plummeted over 80% (from a price of $10.34 to $1.94) in two days. See Figure 1.

Figure 1: LJM Preservation and Growth Fund Class I, Stocks and Bonds, 2014-2018

The LJM Capital Preservation and Growth Fund was launched in January 2013 and sold in three different share classes (ticker symbols LJMAX, LJMCX, LJMIX). The Fund had net assets of $768 million as of the latest Annual Report (available here) filed on October 31, 2017. If the Fund’s net assets were similar on February 4, 2017 immediately before the losses, investors in the Fund lost approximately $600 million in two days.

The Fund’s Prospectus (available here) defines the Fund’s objective as follows: “The LJM Preservation and Growth Fund (the “Fund”) seeks capital appreciation and capital preservation with low correlation to the broader U.S. equity market.”

Returning to Figure 1, the LJM Fund’s total returns are smoother than the S&P 500’s total returns but the Fund suffered large losses in 2014 and 2015 when the S&P 500 dropped. This pattern marks the Fund’s strategy of picking up nickels and dimes in front of a steamroller.

More detail is given in the description of the principal investment strategies which reveals that this Fund is actually designed to pursue an uncovered short options-trading strategy:

“The Fund seeks to achieve its investment objectives by capturing gains on options sold on S&P futures contracts that can be purchased (“closed”) at a later date for a lower price than the price realized when originally sold.... In the aggregate, the Fund is typically “net short” in the portfolio of contracts that it holds, which means that the Fund holds more uncovered option contracts than covered.”

The prospectus goes on to define an uncovered option as one in which the underlying asset is not actually held by the investor or - more precisely - the short option is not offset by a corresponding long stock, option or futures position.

The Fund’s investment strategy can be discerned from the Fund’s October 31, 2017 holdings. The Fund held long and short put and call on S&P 500 futures and held money market funds as collateral for the short options positions. The portfolio therefore has 5 categories of assets: money market Funds, purchased puts and sold puts and purchased calls and sold calls, (in options parlance, selling a put or call option is also called “writing” the option). The 4 categories of put and call option trades can be combined in a portfolio in various ways and can give rise to a myriad of different payoff structures. However, the LJM Preservation and Growth Fund was combining options in a very specific way.

The LJM Preservation and Growth Fund was inaptly named as it pursued the opposite of a capital preservation and growth strategy. LJM was implementing an options trading strategy called a short strangle which has unlimited downside (so no preservation) and limited upside (so no growth). Unfortunately for investors in this Fund, the option strategy is aptly named.

Figure 2a-2c illustrate short strangle payoffs. The Fund sells an out-of-the-money (strike price below the current index level) put option, receiving an upfront payment called a premium. In our example in Figure 2a, the Fund sells a put option with a strike price of $45 when the index level is $50 and receives a $1 premium. At expiration, the Fund will lose $1 for every $1 the index closes below $45. If the index closes below $44 (a $6 drop from the $50 index level when the Fund sold the put option), the Fund will have a net loss on the put option.

Figure 2a: Short Put Option Payoffs

The Fund also sells an out-of-the-money (strike price above the current index level) call option. In our example in Figure 2b, the Fund sells a call option with a strike price of $55 and receives a $1 premium. At expiration, the Fund will lose $1 for every $1 the index closes above $55. If the index closes above $56 (a $6 increase from the $50 index level when the Fund sold the call option), the Fund will have a net loss on the call option.

Figure 2b: Short Call Option Payoffs

Combining the short put option in Figure 2a with the short call option in Figure 2b creates the short strangle in Figure 2c. If the index closes above the $45 strike price of the put option sold short and below the $55 strike price of the call option sold short, the Fund keeps the $2 sum of the put and call option premiums as profit. If the index closes either below the put option’s $45 strike price or above the call option $55 strike price by more than the $2 premium received, the Fund suffers losses on the strangle.

Figure 2c: Short Strangle Payoffs

The Fund’s holdings are a little more complicated than our short strangle example. The Fund sold put options with lower strike prices and bought put options with higher strike prices. In isolation this portion of the portfolio creates a bear put spread to the extent the put options bought and sold are in the same quantity and have the same expiration. Setting aside changes in volatility for now, a bear put spread profits if the underlying index declines.

Matching up some of the sold put options with the higher strike price put options bought leaves the remaining options naked put options which lose money if the index declines.

The Fund sold far more put options than it bought in order to generate a positive net premium on its put transactions because the lower strike price options the Fund sold were worth less per share covered than the higher strike price put options it was buying.

Once the long and short put positions were placed, if none of the puts finished in the money, the payoff to the Fund is the net premium (difference between the higher premiums garnered from selling puts than it paid to buy puts).

The Fund also sold more call options than it bought. This call-option half of the strangle strategy worked in a similar manner to the put-option half of the strategy. If the calls finished out of the money, the Fund kept the net premium which was positive since it sold enough more of the lower value, high strike call options than it bought of the higher-value, lower strike price call options.

The Fund’s strategy was a bet that market volatility would not increase significantly and that the market index level would not change significantly. An unchanged index level would cause the options to expire worthless and the Fund would make money from the premiums it took in selling put and call options. However, the insidious by-product of this strategy is that if the stock market increases or decreases by a significant amount, the Fund suffers extreme losses. Further, the Fund was short volatility through the net short put and call options and would suffer losses if expected future volatility increased significantly even if the stock market index level was unchanged.

 The payoffs at maturity plotted in Figure 2 do not capture significant gains or losses which may occur prior to expiration resulting from increases in volatility even if the index level is unchanged.

To further illustrate the Fund’s strategy, we looked at the October 31, 2017 holdings of the Fund listed in Table 1.

Table 1: LJM’s October 31, 2017 Option Portfolio Market Value

Table 2 reports the sensitivity of the market value of the Fund’s portfolio of options to changes in the underlying index and to changes in the volatility implied by its options. On October 31, 2017, LJM’s portfolio of options had a market value of -$7,154,191.

Table 2: Sensitivity of LJM’s Portfolio Market Value to Changes in Index Level and Volatility

If the underlying index fell 5% instantaneously, the option portfolio’s market value would fall over $30 million to -$37,597,244 because the market value of its large short put option position would increase far more than the market value of its smaller long put position. Surprising to some perhaps, holding the index level constant and increasing the implied volatility 20% (doubling it from 20% to 40%) would cause this option portfolio’s market value to fall $274 million to -$281,470,698. Combining both a 5% decline in the index and a 20% increase in the implied volatility would cause the market value of LJM’s October 31, 2017 option portfolio to fall $378 million to ‑$385,231,428. That is approximately what happened to the Fund in early February. The losses were larger than what we predict back on the October 31, 2017 holdings suggesting that the Fund increased the riskiness of its holdings between October 31, 2017 and February 4, 2018.

The Fund held short and long put and call options on the S&P 500 futures at four different exercise dates. It is typical in options research to construct a payoff diagram that shows how the option strategy pays off given different levels of the underlying security at expiration. Figure 3 below shows such a payoff diagram. There are four lines – each corresponding to the payoff associated with one of the four expiration dates.

Figure 3: Payoff at Options Expiration for LJM

The strategy for each expiration date is basically the same. The Fund makes a small amount of money if the S&P 500 stays in an approximately 400-point band from 2260 to 2660. If the index closes outside of that band, the Fund can lose a nearly unlimited amount. The band is centered close to the level of the S&P 500 in the fall of 2017, so the band can be thought of as +/- 200 points from the then-current level of the index. The S&P 500 fell 240 points over the fateful week in early February. Note also, that there is very little possibility of growth in this Fund. If the index goes up or down significantly, the Fund loses. It cannot be thought of as a growth strategy. It is a limited income strategy with massive downside risk.

 Figure 3, however, only tells part of the story. The drop in the index, while large, was not nearly great enough for the Fund to have incurred an 80% loss. Figure 3 shows the payoffs to the strategy at the expiration date. Option prices prior to the expiration date can be much more volatile and much more prone to wide swings than the price of an option at the expiration date. This is because if we are not yet at expiration, the index has more time to continue to move and push yet-to-expire options deeper into the money.

 In order to illustrate how the Fund’s strategy performed prior to expiration, we simulated the returns to the Fund for different changes in the market environment. We concentrated on two market environment variables to which option prices are sensitive: the change in the level of the S&P 500, and the implied volatility of the S&P 500. Volatility means how variable the underlying is likely to be over the remaining term of the option. Higher volatility is characterized by large movements up and down of the underlying index. In periods of greater volatility there is a greater probability of a big move in the underlying increasing the value of a long option position (because it becomes more likely that the underlying is going to push through and significantly past the strike price). Since the Fund was net short options, a rise in volatility causes losses to the value of the positions.

Figure 4 below shows the changes in net assets that the LJM Fund would have experienced on October 31, 2017 given various changes in the level of the S&P 500 and in the implied volatility of the S&P 500. The x-axis is changes in the level of the S&P 500. The midpoint of this axis, 100%, represents the point at which there is no change in the level of the index. As you move to the left (right), the index is decreasing (increasing). The y-axis is how much the net assets of the Fund change. The curved colored lines represent different levels of implied volatility. The top curved blue line is the case where the implied volatility does not change. Note that if the index level stays close to 100% (stays level) the net assets of the Fund remain unchanged. For large changes (either up or down) in the index, the net assets of the Fund decrease.

LJM’s short strangle strategy profits were highly sensitive to changes in volatility. Increases in volatility would cause large losses even if the S&P 500 Index level was unchanged. A 5% decline in the S&P 500 with no change in volatility would correspond to losses of less than 5%, but when combined with a 20% increase in volatility result in losses of 50% to LJM’s October 31, 2017 portfolio.

Figure 4: LJM Fund Sensitivity to Index Levels and Changes in Implied Volatility

As mentioned earlier, the S&P 500 fell approximately 240 points in the first few days of February. This by itself would have caused losses to the Fund. However, of greater import was the increase in the volatility of the S&P 500. The dramatic swings in the index increased the likelihood that the put options the Fund had shorted would move deeply into the money and dramatically increased put prices.

Figures 3 and 4 show exactly what Fund managers knew about the risk of their strategy. It is also what brokers, who recommended the fund, could have easily known simply by looking at the annual report. These figures can be drawn at any time based on the structure of the portfolio and the then-current market environment. It is clear that the gigantic risks that this Fund posed were known and were understood, even as the Fund touted capital preservation and growth, two objectives that could not be met with this strategy. At this writing, it is not clear what actions the Fund managers took in reaction to the market gyrations. However, it seems likely that the Fund sold or was forced to sell out of their options positions. The Fund has not recovered, trading as of this writing at $1.98. This, even as the market has recovered over half of its early February losses and volatility has declined significantly.

Someone should look into this.