Many of these products were sold on a leveraged basis, meaning investors buying notes tied to measures of volatility could take large bets for little upfront cash. One theory that's emerging: the curious case of the tail wagging the dog.
The gauge of US stocks volatility known as VIX, which tracks the volatility implied by options on the S&P 500, recorded its biggest one-day surge in more than two years as investors rushed to buy derivative products to protect against a further slide in stock prices.
Two investment vehicles tied to U.S. share market volatility collapsed after the S&P500 closed earlier this morning, and it could have significant implications when markets reopen later tonight.
The stock market has begun to recover from its epic slide - in which the Dow Jones industrial average lost as much as 10.7% of its value at one point. After the dust settled, the combined assets in the two exchange-traded products shrank to $135 million. And the ProShares Short VIX Short-Term Futures ETF plunged 85%.
"If anything, we should have been surprised by how low volatility was to begin with", said Andres Garcia-Amaya, CEO of wealth management firm Zoe Financial.
The problems these tracker funds are facing should not cause permanent damage to the broader market, investors said, as the total assets under management pales in comparison to the broader options market and equity market overall.
While the VIX enjoyed a record rise in the past two trading days, the forced closure of short volatility ETNs means traders do not have to hedge these trades with Cboe's VIX futures any more.
The Cboe Volatility Index - known as the VIX - is used as a gauge of the level of volatility in markets. "If they don't, it is very likely that they are halted" on Tuesday, said Black Peak Capital's Aniston.
But most people shouldn't panic, analysts say. S&P 500 Dynamic VIX ETN Ipath (XVZ)'s Williams %R presently stands at -39.07. Since it trades as an ETF, it should theoretically open regular trading on Tuesday down about 95% from the previous day's close. The CBOE has a video explaining some of Monday's VIX trading activity. The opposite is the case when the RSI line is heading lower. During other eruptions of volatility - the aftermath of China's shock devaluation of the yuan in August 2015, for instance - volatility in stocks, bonds, currencies and even oil jumped.
To be sure, the seeds for a pull-back had been sown well ahead of 3 p.m. on Monday. In the five years leading up to market close yesterday, the VelocityShares Daily Inverse VIX Short-Term ETN (NASDAQ:XIV) generated a compounded annual return of 35.7%, easily outpacing the stock market average.
But even as 2018 kicked off with soaring stocks and subdued volatility, signs of complacency in short-vol land had cropped up. Inverse volatility ETNs hold short positions in these futures contracts, and short sellers know buying the underlying contracts is part of the process of closing out these short positions.
If investors had been expecting that to change, the VIX would have been moving higher before Monday.