If you've ever traded in leveraged ETFs or ETNs, you know they can be wildly volatile. If you've ever dabbled in leveraged inverse products that are thinly traded in the OTC market, you're taking it to a whole new level.
And then there's the case of the VelocityShares Daily 3x Inverse Natural Gas ETN (DGAZF).
In case you missed it, here's the one-month chart for the note.
As little as a few days ago, it traded at $400 a share. A week later, it was at more than $24,000. Today, it's back down to a "modest" $13,000.
So, how does a delisted triple-leveraged inverse natural gas exchange-traded note (yes, that's a lot to say) increase 60-fold over the matter of a week? The short answer is we don't know for sure, but we have some ideas. There's a lot to unpack here, so let's take it step by step.
History Of DGAZF
DGAZF is the over-the-counter version of the now delisted VelocityShares Daily 3x Inverse Natural Gas ETN (DGAZ). Back in June, I wrote about Credit Suisse deciding to delist its suite of ETNs in order to "better align its product suite with its broader strategic growth plans". I focused on the gold and silver ETNs closing in the article and only mentioned the natural gas ETNs in passing, not realizing they'd become the big story more than a month later.
The problem is that Credit Suisse didn't actually close the note altogether. It merely delisted it, which is the equivalent of just letting it die a slow death. Since it got moved to the OTC market and became DGAZF, it's still available to trade, but it's a very thinly traded market susceptible to all kinds of trading quirks.
Much like the one it's experiencing right now.
DGAZF Begins Trading At Ridiculous Premiums To NAV
The real action in this note began at the beginning of August. Bloomberg's Eric Balchunas noted that's around the time that DGAZF began trading at 3 times its underlying NAV.
By Monday, it began trading at more than 8 times its NAV.
By the end of the trading day on Monday, it began trading at 27 times its NAV. In other words, some traders were willing to pay $3500 for roughly $120 of assets.
Of course, that wasn't the end. DGAZF got as high as $24,000 per share before retreating on Wednesday. No, there was no crazy spike in natural gas prices. This is simply the story of a security gone nuts.
How Did This Happen?
As far as I can tell, there's nothing nefarious at play here, but there is perhaps some irresponsible behavior.
The root of the problem comes from Credit Suisse deciding to delist DGAZ and let it drift to the OTC market instead of just closing it out altogether. Credit Suisse still makes fees on the notes, so perhaps that's part of the reason, but if you're essentially going to abandon it, you're doing a disservice to investors who happen to stumble across it or decide to trade it.
Another contributing factor is the fact that no new shares of DGAZF are being issued. That leaves investors who 3x negative exposure to natural gas fighting for what few shares are available on the market. ETFs, for example, have a creation/redemption mechanism in place that largely keeps shares trading at or near their underlying NAV.
DGAZF is essentially trading like a rare coin now. If there are only a handful available in the world, collectors might be willing to pay a crazy premium above its value in order to get their hands on it.
I think that's exactly what we're seeing here.
Why exactly investors feel the need for triple leveraged exposure to natural gas right now is a mystery. Maybe it's portfolio positioning ahead of the cold weather months, but who knows. But, apparently, there are indeed a handful of traders out there who want what DGAZF is offering and are willing to pay a big price to get it.
What Happens Now?
The only logical answer is that Credit Suisse needs to officially close the ETN. This has already been suggested by a few other observers and I couldn't agree more. Letting this float out there in the OTC market like it has is creating a dangerous situation for unwitting investors and some are inevitably going to experience huge losses.
DGAZF is already down 50% from its peak in just a couple of trading days and I suspect it's heading much lower from here. The only problem for current shareholders is that the supply/demand imbalance that created this spike in the first place is also the issue that likely sends it right back to where it was.
This is part of the danger in trading unfamiliar securities. For example, ETNs aren't the same as ETNs. They're structurally different and come with their own set of quirks.
Also, trading in the OTC market isn't the same as trading on the major exchanges. The number of traders is much, much lower and trading costs can be huge.
And, of course, leveraged inverse products come with their own risks.
Thankfully, this is an especially unusual situation, but one that can indeed happen to unsuspecting folks.
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