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Regulatory Sanctions

This Broker Played a Volatility Game He Didn’t Understand

September 25, 2017

by Howard Haykin


When reading this post, consider how a broker-dealer could have adequately supervised the errors of this registered rep. For example, why wouldn't a firm run a program that, say each month, reviews customer accounts for obvious short-term trading vehicles that have been held for extended periods? A basic protection for firms, customers, and (as it applies in this AWC) registered reps.


James Flower agreed to serve a 3-month suspension and to complete 10 hours of continuing education on complex products to settle FINRA charges that he recommended that 13 of his customers invest in a highly volatile exchange-traded note without having a reasonable basis for recommending the transactions. No monetary sanctions were imposed in light of Flower’s financial status.


BACKGROUND.    Flower, a resident of Melville, NY, has been in the industry 19 years with 17 firms. From 2010 to 2014 he was associated with Global Arena Capital, a former FINRA member firm, serving as a General Securities Representative. Flower currently is registered with another FINRA member firm. Flower had no disciplinary history.


FINRA FINDINGS.    During 2013 and 2014, Flower recommended that 13 of his customers INVEST in a security known as the iPath S&P 500 VIX Short Term Futures ETN ("VXX"), a highly volatile exchange-traded note (“ETN”), without having a reasonable basis for recommending the transactions.


Flower believed (incorrectly) that the ETN traded inverse to the S&P 500 index, and so he recommended that customers PURCHASE AND HOLD the ETN as a hedge to an anticipated overall market decline. However, in doing so, Flower’s 13 customers suffered losses in excess of $249,000 after holding their shares for periods ranging from 2 weeks to over 1 year. Flower lacked a sufficient understanding of the mechanics of the exchange-traded note to form a reasonable basis upon which to recommend the purchase of it to his customers.


The VXX Exchange-Traded Note.  The VXX is an ETN that offers investors exposure to the returns of one- and two-month futures contracts on the CBOE Volatility Index (the "VIX Index"). The VIX Index is designed to measure the market's expectations of volatility in large cap U.S. stocks over the next 30-day period. Although the VXX moves in the opposite direction of the index it tracks, it has its own independent risks.


Most significantly, it is generally expected to lose value as time moves on, and thus it is rarely if ever considered to be a prudent long-term investment. The value of futures contracts on the VIX Index generally decreases over time. As a result, the VXX is rarely if ever suitable as a long-term investment, but instead is generally held for brief periods measured in days for short-term speculation or to hedge a portfolio against a market downturn, rather than months or even weeks.


FINANCIALISH TAKE AWAY.    The VIX Index is often referred to as the “investor fear gauge” and, as FINRA correctly notes, it’s best suited as a short-term trading vehicle - not as an ‘investment’. FINRA is also correct in noting that VXX has its own risks – so it may not necessarily move in the opposite direction of the index it tracks.


That said, it would have been instructive for FINRA to have provided some context. For example, what was the scope of the customers’ losses as a percentage to their overall holdings? [FINRA so often refers to percentages – why not now?] Or, what was the direction of the market during the “Relevant Period?”


  • If we presume that the collective portfolio valuation of Mr. Flower's 13 customers was in excess of $8 million, then the $249,000 in losses would amount to ~3% of their holdings - not draconian for a hedged bet. Unfortunately, this information is not available – though, admittedly, it would not have pardoned Mr. Flower's errors.


  • During the period, the stock market was bullish, with the S&P 500 Index running up from $1,426 (on 1/2/13) to $1,872 (on 3/31/14). That means that Mr. Flower's bearish bet was a loser.


This case was reported in FINRA Disciplinary Actions for August 2017.

For details on this case, go to ...  FINRA Disciplinary Actions Online, and refer to Case #2014040644001.