In recent times, the U.Sstock market has witnessed a rollercoaster of excitement, particularly with the explosive rise in prices for stocks associated with BitcoinAmong these, MicroStrategy, an organization that has transformed itself into a major player in the cryptocurrency world, has drawn significant attentionWith Bitcoin skyrocketing nearly 40% in a brief period, MicroStrategy's shares surged an impressive 67%. The company's stock has exploded in value this year, rising a staggering 455%, far surpassing Bitcoin's gains, which makes the situation all the more intriguing.

Taking advantage of this bullish atmosphere, two leveraged ETFs targeting MicroStrategy were launched and quickly gained popularityThe Defiance Daily Target 2x Long MSTR ETF (MSTX), initially providing investors with a 1.75x leverage since its August debut, adjusted the leverage to 2x in October, while another fund, the T-Rex 2x Long MSTR Daily Target ETF (MSTU), followed suit in September

Within just six months, the assets managed by these ETFs ballooned to around $5 billion, a clear indication of the massive demand.

However, an unexpected turn of events has emerged as a stark reminder that the stock market can be quite unforgivingIn late November, when MicroStrategy's stock fell by 1.9%, MSTU plummeted 6.2%, exceeding the anticipated twofold movementConversely, when MicroStrategy’s stock rebounded by 9.9%, MSTU only achieved a return of 13.9%, falling short of the expected 19.8%. These discrepancies have sparked outcry on social media, with investors expressing feelings of betrayal, suggesting that the mathematics underpinning these products have failed them.

The promise of double returns has seemingly turned into a bitter lesson, as investors anticipated significant upward movements but were instead confronted with greater losses than anticipatedUnderstanding where this went wrong is essential

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Typically, leveraged ETFs utilize derivative instruments like swap contracts to achieve their daily investment objectivesHowever, the rapid increase in the value of MSTX and MSTU pushed their major brokers to the limits of their capacity, forcing these ETFs to shift towards utilizing options contracts insteadUnfortunately, trading options comes with its own challenges, including wider bid-ask spreads and heightened price volatility, leading to greater tracking errors.

At the core of the issue is the fact that the unprecedented growth of these high-leverage ETFs has surpassed the risk thresholds of some Wall Street institutionsBitcoin is inherently volatile, and with MicroStrategy's stock commanding a substantial premium due to exposure to this volatile asset, layering additional leverage results in greater risksAs demand surged, the available swap contracts became insufficient to cover the expansive interest in these funds.

Single-stock ETFs, such as the recently permitted products in 2022, have become a novel concept in the U.S

stock marketOver the past two years, the demand for single-stock ETFs linked to highly volatile tech giants like Nvidia, Tesla, and Apple has skyrocketedRisk-tolerant investors have used these tools to exploit single stocks in both bullish and bearish scenariosTo date, most of these ETFs have performed in accordance with their marketing promises, achieving their targeted daily performance goals.

Unlike traditional ETFs, which hold a basket of stocks, single-stock ETFs do not hold the underlying stock, instead solely tracking one stock through derivative contractsThe most commonly employed strategy is the total return swap, which provides these ETFs the ability to precisely double the daily performance of the stock they are targetingHowever, the explosive demand surrounding MicroStrategy's leveraged ETFs created substantial problems in securing sufficient swap contracts.

In response to the rising price of MicroStrategy shares, the CEO of Tuttle Capital Management, which manages MSTU, received discouraging news in October: The brokerage firm could no longer provide the swap contract exposure necessary for the ETF to operate as intended

With only three brokerages willing to collaborate due to the stock's volatility, the CEO found himself unable to secure the required swap amountsWhen he needed $1.3 billion in exposure, the primary broker could only offer $20 to $50 million.

Consequently, Tuttle resorted to employing call options to attempt to meet performance goalsMSTX, the competitor of MSTU, faced similar challenges, with its management resorting to options shortly after its launch to maintain the required leverageHowever, compared to swap contracts, options are less precise in achieving ETF investment objectives due to significant price fluctuations and the effects of market movements disproportionately impacting larger buyers like ETFs.

The underlying issue stems from the high-risk nature of MicroStrategy as an ETF underpinningTuttle acknowledged, “If the ETF's underlying asset were Procter & Gamble, I could get as much swap exposure as I wanted, but MicroStrategy is a different story altogether.” Originally, MicroStrategy was a lesser-known enterprise software company that decided to invest in Bitcoin to hedge against inflation in August 2020, right after the outbreak of the pandemic

This decision triggered a monumental change, propelling the firm to become a global leader in Bitcoin holdings.

Over the past four years, MicroStrategy has disclosed over 40 Bitcoin purchase announcements, amassing a staggering 402,100 Bitcoins, accounting for roughly 2% of the total circulation and making it the publicly traded company with the largest Bitcoin holdings in the U.SInitially, the company utilized cash flow for purchases but gradually leveraged its acquisitions through convertible notes and is now exploring additional financing options for future Bitcoin investments.

In conjunction with their third-quarter financial report, MicroStrategy recently unveiled a “21/21 Plan,” aiming to raise $42 billion over three years through $21 billion in equity and $21 billion in debt to acquire even more BitcoinThe financing numbers reflect the company's passion for cryptocurrency, with the number “42” alluding to a famous line from the sci-fi series “The Hitchhiker's Guide to the Galaxy,” dubbed by MicroStrategy’s executive Phong Le as a number with special significance

He explained that “21” is a magical number within the Bitcoin universe, given that Bitcoin's maximum supply will always be limited to 21 million coins.

As Bitcoin surged due to favorable policy expectations, MicroStrategy, taking an extreme position on the cryptocurrency, saw its market price soar, leading to a rapid inflation of its stock market capitalizationYet, concerns regarding the overall risk have also intensifiedCurrently, the total value of MicroStrategy's Bitcoin holdings sits at around $40.2 billion, while enthusiastic investors have pushed the company's market value to over $80 billion—more than double the value of their Bitcoin holdings.

This premium, built upon Bitcoin's historically volatile nature, looms over the ETFs, which now face the compounded risks of intricate derivative strategies layered on top of inherently unstable assetsThere are warnings suggesting that in extreme cases, should MicroStrategy's stock plunge by 51% within a single day, these leveraged ETFs could confront a total collapse reminiscent of the “Volmageddon” event in 2018.

Prior to 2018, the U.S

stock market volatility index (VIX) remained complacently low, with investor sentiment leaning towards optimismHowever, during a dramatic spike in early February 2018, the market endured considerable sell-offs, prompting the VIX to surge from 17 to over 37 in a single day—a jump of over 100%, with figures briefly exceeding 50 in subsequent days.

This extreme volatility wreaked havoc on numerous ETFs and funds reliant on low-volatility strategiesThe most devastating impacts were felt by two inverse VIX ETFs — the VelocityShares Daily Inverse VIX Short-Term ETN (XIV) and ProShares Short VIX Short-Term Futures ETF (SVXY) — which saw their asset size shrink from $3 billion to a mere $150 million in a matter of daysXIV, in particular, decimated by a staggering 96% loss in a single day, was ultimately liquidated by its issuing company, Credit Suisse, at the expense of its investors, many of whom suffered tremendous losses