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Another ETN Tail Event

The VelocityShares 3x Inverse Natural Gas ETN (DGAZF) surged more than 3600% in just five days when, according to our calculations, it should have dropped about 60%. This was another exchange-traded note tail risk event.

Instead of trying to enumerate the reasons why this tail event occurred as was done in mainstream financial media and blogs, we will focus on the data and what these tail events could mean for traders and investors.

Below are daily charts of the ETN and continuous natural gas futures. Their 60-day correlation of daily returns is also shown on the chart.

It may be seen that the ETN and the futures were highly anti-correlated until the tail event occurred. The anti-correlation was due to the fact that this was an inverse ETN.

However, a few days ago the anti-correlation was suddenly violated and from an average of about -0.85 it surged close to 0. This was a disaster for traders and investors with short positions in the ETN. Losses for the shorts were estimated anywhere from $30 million up to $300 million.

Although shorts were correct about direction in the last few days and should be making about 50% to 60%, they ended up with losses in excess of 400% and maybe up to 3600% depending on when they opened the trade.

Which brings us to the important point: Anyone who trades ETNs in commodity space or even volatility (remember XIV? ) without first reading the fine print in the brochure risks facing tail events.

These speculative ETN instruments and especially the leveraged ones are suitable only for day traders who understand the risks. Investors and especially fund managers who invest in these instruments with the objective of leveraging positions (for example shorting DGAZF to leverage potential losses in the underline) may end up deep in the red and even driven to liquidation.

Although some talked about possible manipulation in this case to squeeze out shorts and then offer them loans to cover the losses, we have no evidence of that. What is important is that these instruments although they trade like equities they are far from that and market participants should understand this. Many ETNs are tail risk time bombs because they are derivatives of derivatives and in some cases, of another level of derivatives on top of that (see this article.)

Charting and backtesting program: Amibroker

Data provider: Norgate Data

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