EXPLAINER-Investors burned as bets on low market volatility implode

(Repeats story first published on Feb. 6 with no changes)

* Volatility spikes from historic lows

* Unwinding of 'short' VIX trades burns retail investors

* VIX was below 20-year average for nearly two years

* Retail investors flee short VIX ETFs: http://tmsnrt.rs/2BGGFiP

* VIX crosses over VSTOXX: http://tmsnrt.rs/2BcwcdK

By Saikat Chatterjee and Helen Reid

LONDON, Feb 6 (Reuters) - Spikes in expected stock price swings in the United States and Europe have sent shockwaves through a market that allows investors to take leveraged bets on the volatility of equity indexes, forcing some funds to close down.

WHAT HAPPENED TO STOCKS?

World stock markets nose-dived again on Tuesday amid concerns about a bond market sell-off and rising inflation.

U.S. stocks, which triggered the global reversal on Friday when payrolls data showed a spike in wage inflation, suffered their worst fall since August 2011 on Monday.

The gauge of U.S. 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.

The trading range for the VIX, or the Cboe Volatility Index, on Monday was 17 points, much wider than the 10-point range the day global markets were shaken by Britain's vote in June 2016 to leave the European Union.

As European markets sank on Tuesday, the region's equivalent to the VIX - the VSTOXX - followed suit with its biggest one-day surge since the Sept. 11 attacks in 2001.

WHY ARE VOLATILITY PRODUCTS POPULAR?

Derivatives contracts tied to the VIX - known as the "stock market's fear gauge" - have grown rapidly in recent years as central bank stimulus and a recovering global economy lowered volatility across asset classes.

With (Other OTC: WWTH - news) day-to-day trading volumes dented by the lower market volatility, banks created products to turn the generally calm market environment into a trading opportunity.

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.

Because many of these products were sold on stock exchanges as exchange-traded funds (ETFs (Shenzhen: 395013.SZ - news) ) or exchange-traded notes (ETNs), retail investors had easier access than before to these highly leveraged trades which were winners for months.

Both the VIX and the VSTOXX have drifted lower since early 2016, staying at depressed levels below their 20-year average for nearly two years - until Monday's slide in U.S. stocks.

The S&P 500 had not fallen by more than 5 percent for more than 400 days, the longest run since the 1950s, according to Mark Haefele, chief investment officer at UBS Wealth Management.

WHAT WENT WRONG?

Because the products bet on market volatility remaining low, or declining consistently, they essentially profit from the difference between the price of volatility now and in one month's time.

Normally, one-month futures contracts on the VIX trade at a discount to the spot price, a structure known as backwardation. That allowed traders to sell one-month futures contracts and make money as those contracts matured.

Friday's rise in volatility put investors on edge, but this week's surge brought the roof crashing down on such trades.

As the VIX surged on Monday, the one-month futures contract rallied more than 110 percent, forcing market participants who had been hoping to profit from its decline to close out their positions well after market hours.

The notional value of contracts on such products traded on Friday was six times the daily average for the last year, said the head of European equity market trading strategy at a bank in London.

"The last two days of trading has thrown a giant bucket of cold water on the short volatility trade and I think we're now in for a prolonged period of elevated volatility generally," said David Lafferty, chief market strategist at Natixis (LSE: 0IHK.L - news) Investment Managers.

Investors said the proliferation of short-term traders, some using computers to trigger trading decisions, had also exacerbated the price swings of the past few days.

"Plentiful liquidity in markets has also allowed fast money, model and algorithmic investors to switch positions from long to short in quick time adding to the downward shift in prices," said Stephen Jones, chief investment officer at Kames Capital.

WHAT'S THE FALLOUT?

The repercussions have been severe for some funds.

Trading in the VelocityShares Daily Inverse VIX Short-Term ETN, ProShares Short VIX Short-Term Futures ETF and VelocityShares Daily Inverse VIX Medium-Term ETN has been halted and all three products had a short-selling restriction placed on them by Nasdaq (Frankfurt: 813516 - news) .

Credit Suisse (IOB: 0QP5.IL - news) , the issuer of the VelocityShares ETN , in which it has a 32 percent stake, said on Tuesday it would redeem the ETNs.

Nomura Securities also said on Tuesday it would redeem its Tokyo Stock Exchange-listed S&P 500 VIX Inverse ETN .

The market capitalisation of short VIX products had ballooned over the past 12 months as retail investors rushed into trades betting on a decline in volatility of U.S. stocks, but fell sharply as the sell-off hit. http://tmsnrt.rs/2BGGFiP

WHAT NEXT?

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.

But these funds, though small, did help amplify the sell-off and the surge in volatility, in a sign that abnormal positioning in derivatives markets can have knock-on effects on the wider market.

This was the first serious test for these ETFs, most of which were launched after the global financial crisis.

Derivatives markets indicated, however, that the spike in volatility of the past few days would not be sustained.

VIX futures contracts fell back on Tuesday to trade at a wide discount to the spot price, showing that traders expected volatility to fall sharply.

During its rapid surge higher, the VIX outpaced the VSTOXX, an event analysts flagged as an extreme move, also suggesting there would be a rapid normalisation.

"The VIX moving over VSTOXX is a rarity... it could be taken as showing how irrational things got over the past day or two," said Russell Rhoads, director of product advancement, global derivatives at Cboe Global Markets.

The impact of the market sell-off on other asset classes has been fairly muted though various gauges have risen reflecting broader uncertainty around markets in the short term.

Bond volatility, as measured by three-month option contracts on Bank of America (Swiss: BAC-USD.SW - news) , has risen to $61 from $58 a week ago, but remains well below a 2016 high of $86.

Derivatives positioning also indicated so-called index dispersion trades - in which investors bet that the price swings in an individual stock will be greater than overall index volatility - are still popular, market participants said.

"A lot of people are still more concerned about individual stock risk than index risk," said the Cboe's Rhoads. http://tmsnrt.rs/2BcwcdK

(Reporting by Saikat Chatterjee and Helen Reid; editing by David Clarke)