Increased Risk in Short & Leveraged ETPs in Volatile Markets
Short and Leveraged ETPs (S&L ETPs) are complex instruments and that bear high risk. This risk is greater during periods of heightened market volatility, and investors face a greater risk of losing all of their investment than in normal times. For example:
More extreme returns: The daily returns of the underlying markets are greater and could result in a move that wipes out the value of a short and/or leveraged product.
Compounding may be severely adverse: The “compounding effect” whereby returns of a short and/or leveraged ETP differ from the short and/or leveraged returns of the underlying asset over any period different to one whole day, is more pronounced and may lead to unexpected returns, particularly for holding periods longer than one day. The compounding will be particularly severe when the market alternates between going up and down daily.
The risk of intra-day restrike is elevated: Intraday restrikes, whereby the product’s leverage is reset in within the standard trading hours of the underlying market, may be more frequent, and may lead to worse results than the investor might have been expecting
Out-of-hours gap risk is elevated: extreme movements in the markets can occur outside of standard trading hours of that underlying market and could lead to the swap provider terminating the product at 0 or little value. This so called out-of-hours gap risk may occur in global markets which trade within or outside of European stock exchange trading hours. Even if this occurs during the trading hours of the ETP, the circumstances leading to such an event may cause liquidity to disappear from the ETP and it may therefore be impossible to trade out of it around its termination. Furthermore, information about such an event may not reach investors until much time after the fact.
The spreads on products may become wider and price/quotes disappear: Short and/or leveraged products have magnified uncertainty compared to their underlying markets and at times when there are extreme market dislocations and record levels of uncertainty, the on-exchange bid-ask spreads may widen or there may be no quotes for periods of time, which may make it difficult to sell an existing position or buy into a new one.
General liquidity risk is exacerbated: Although the product has features intended to mitigate the risk of its value being wiped out, it may still be completely wiped out. This is more likely to happen if volatility is combined with situations of low liquidity or in severe market dislocations; however, it may happen in more extreme circumstances as well. In such circumstances, the product may be terminated at 0 value after an extreme move or extraordinary event even if its theoretical value using its pricing formula never touches 0, and even if the market subsequently rebounds or stabilises.