Long volatility ETFs and ETNs go through reverse splits regularly.
What causes the need for a reverse split?
Most of the time, VIX futures are in contango (futures are priced higher than spot VIX). As the linked article explains, this is a huge drag on the performance.
Furthermore, a leveraged ETF, such as UVIX (2x) and UVXY (1.5x), will lose value to the so-called leverage decay. The higher the leverage factor, the more rapidly a long VIX Futures ETF declines.
As the ever declining prices of these long volatility products approach $5, issuers usually execute a reverse split.
At this price level, trading costs go up for many market participants:
- Many brokers still charge a penny per traded share.
- Option contracts are usually issued at $0.50 gaps at this price level. This makes many option strategies difficult to execute, as the gap per strike is 10% around $5. This situation is different from when a long vol product is at $25 and has options with strikes at every full dollar (gap per strike is 4% around $25).
- Most brokers charge a fixed dollar amount per traded option contract. This makes option trading at low underlying prices less profitable. Avoid this issue by using this recommended broker!*
Please note that there is no guarantee that reverse splits will be executed at $5 – or any other price point. Some issuers (particularly ProShares) are known for executing reverse splits across their entire ETF/ETN portfolio at the same time. As a result, some volatility ETFs and ETNs can be reverse split at higher or lower prices than $5.
What is a reverse split?
“Reverse split” describes the process of the issuer reducing the number of shares.
For example, a 1 for 10 reverse split means that a current holder of 100 shares will own 10 after the execution of the reverse split. At the same time, the value of the shares increases by 10x.
Assuming UVXY is priced at $5 at the time of a 1 for 10 reverse split, a holder of 100 shares (worth 100 * $5 = $500) will receive 10 shares (worth 10 * $50 = $500).
Important to note: A reverse split does not affect the value of a position in UVXY, UVIX or VXX.
How does a reverse split affect UVIX / UVXY / VXX options?
There is an automatic adjustment of the option contract regarding strike and number of shares. Let’s look at an example!
Assuming a UVXY $5 Call and current UVXY price of $5, an investor holds one contract. This contract represents the right to buy 100 shares at $5.
If at expiration the price of UVXY is 20% above the strike, the option can be exercised at a profit: ($6 – $5) * 100 = $100
Assuming UVXY goes through a 1 for 10 reverse split before expiration, two adjustments are made.
- The strike price of the option is multiplied by 10 and becomes $50.
- The number of underlying shares is divided by 10 and becomes 10.
As a result, post-reverse-split, the option contract represents the right to buy 10 shares at $50.
If at expiration the price of UVXY is 20% above the strike, this contract is profitable: ($60 – $50) * 10 = $100
The important conclusion: A reverse split of a long volatility ETF/ETN does not affect the value of options.
What should you do with these adjusted option contracts?
The liquidity of these adjusted option contracts dries up quickly.
As demonstrated in the previous section, the value of an adjusted option contract at expiration will be identical. However, the liquidity (and therefore bid/ask spreads) will not be the same.
Therefore, it is strongly recommended to roll from the adjusted contracts to “new” standard contracts (based on 100 underlying shares) as quickly as possible.
This advice is particularly important to traders who want to keep the flexibility to trade their option contracts in the period between the execution of the reverse split and the expiration of the option contracts.