How An ETF Can Drop 100% In A Day

It's never happened, but it could.

Last week I wrote a blog in response to some questions readers had about the VelocityShares 3X Long Crude Oil ETN (UWTI), a popular product for trading the oil market with leverage. In that post titled "Can An ETF Go To Zero," I ultimately concluded that, "Technically, UWTI could fall extremely close to zero, though it would never reach that point."

My former colleague, ETF Analyst Boris Valentinov of FactSet, alerted me that there is one scenario that I overlooked.

"There is a way to actually go to zero, although very unlikely," he said. "If you have, say, a 3x-leveraged fund and the market goes down by 34 percent that day—the fund is done."

Boris is, of course, correct. If oil prices drop by more than 33.33 percent, UWTI will lose 100 percent of its value and holders will be completely wiped out.

UWTI Did Flirt With Disaster
As Boris also points out, it's never happened in the U.S., though it's certainly a possibility. A look at the data reveals that the biggest daily decline for UWTI so far was on Nov. 28, 2014, when the ETN lost 24.8 percent of its value. That came on a day that crude oil dropped about 10.2 percent, one of the bigger declines in recent history.

Yet despite the big moves in crude during the last year or so, the commodity hasn't seen anything near the extreme volatility that took place during times in the past. In fact, the drop in crude oil on Nov. 28, 2014, was only the 21st-largest in history.

The real monster moves came in the late '80s, early '90s and 2001, well before UWTI's launch in February 2012. Here are the five biggest single-day moves in front-month WTI crude oil futures:

At the top of the list is the move in January 1991, when crude oil tumbled a whopping 33 percent in the midst of the Gulf War, after it became apparent that the conflict would not lead to significant supply disruptions as initially feared. On an intraday basis, oil prices fell as much as 34.06 percent.

So yes, however unlikely, it is possible for crude oil to fall that much and send UWTI to zero.

On the flip side, if crude oil rallied hard enough, that could present challenges for UWTI's sister product, the VelocityShares 3X Inverse Crude Oil ETN (DWTI). However, there's never been an instance where oil has risen anywhere close to 33 or 34 percent in a day. Here are the top five biggest single-day increases for crude:

Not Just Oil

Leveraged oil ETNs are not the only products that could drop to zero in the event of a big, single-day move. Leveraged products tied to other assets can also be wiped out, as can nonleveraged, inverse products. In that case, if the asset the inverse ETF tracks doubles in value (up 100 percent), that inverse ETF would fall to zero.

With oil being a particularly volatile commodity, the risk is higher for products tied to that commodity. Other volatile areas where leveraged products are available are natural gas, silver and the VIX. (Broad stock market or equity sectors are unlikely to move anywhere near the 33-34 percent daily threshold to see a wipeout in their related leveraged products.)

UGAZ & DGAZ At Risk

Perhaps the leveraged products that are most at risk of seeing a wipeout are those related to natural gas. Regarded as perhaps the most volatile commodity of all, natural gas has seen 98 single-day double-digit percentage moves since futures began trading in 1990 (66 on the upside, 32 on the downside).

Here are the five largest rallies:

And here are the five largest declines:

None of the biggest moves happened in the period since the February 2012 launch of the VelocityShares 3X Long Natural Gas ETN (UGAZ) and the VelocityShares 3x Inverse Natural Gas ETN (DGAZ). But clearly, if those ETNs were around back then, there were at least a few instances in history when they would have been wiped out or nearly wiped out.

The Feb. 24, 2003, spike in natural gas, which came on the heels of a cold snap and low inventories, would have certainly pushed DGAZ down to zero. While there haven't been any moves of that magnitude recently, there have been some eye-catching fluctuations.

On June 14, 2012, natural gas prices rocketed higher by 14.2 percent, leading to a stunning 42 percent decline in DGAZ.

It's not beyond the realm of possibilities to have natural gas rallies or declines of more than 30 percent. It's happened before and it can happen again.

Bottom Line

Debating whether an ETF can go to zero is an interesting mental exercise—one that highlights the tremendous risks associated with leveraged and inverse exchange-traded products. If history is any guide, it's only a matter of time before we see the first of these securities fall to zero following a breathtaking move in the underlying asset that it tracks.

At the time of this writing, the author held no positions in the securities mentioned. Contact Sumit Roy at [email protected].