Close
FEATURED STRATEGY

Scientific Breakthrough: No Chemo, No Radiation, But Kills Cancer Dead!

Five-Minute Fortunes12 million Americans have cancer. But this tiny $75 million company just discovered a safe way to eradicate the disease.

(Must see!) And by investing in this tiny little stock… investors could grab 5,320% gains in as little as 3 minutes. 

Click here now for details.

 

How to Trade Volatility and Make Money with Limited Risk

Is stock-price volatility an asset class separate from stocks or simply a risk factor of stocks? To be a separate asset class, it must have an expected rate of return that is positive and a correlation with stock returns that is not simply the same as owning stock or shorting stock.

Volatility Measures Risk of Stock-Price Declines 

Studies have shown that adding S&P 500 volatility futures to a stock portfolio reduces drawdown risk, but so would simply holding cash or shorting the S&P 500 index. The real issue is whether owning volatility futures by itself generates a positive return over the long run and the answer is probably not since volatility is mean-reverting and moves in a contained trading channel up and down. There is evidence that one can enhance stock returns with a volatility allocation if one engages in dynamic market timing that only buys volatility when it is low and sells volatility when it is high (pp. 9-10), but this rate of return is more a reflection of trading skill than the inherent value of volatility itself.

As one commentator puts it:

Volatility is a form of risk that most investors dislike, so they will pay somebody else to take that risk off their hands for the same reason people buy fire insurance on their house. To the extent that one takes a consistently short position on volatility, they will earn a premium every period but sustain big losses occasionally (as was the case in parts of 2008), just like an insurer paying out a claim. This is the basis of the higher returns obtained by many hedge funds, not any clear advantage of skill. Houses are an asset, but not a fire insurance policy on the house that has no cash value.

Volatility-linked securities are hedging instruments that are just an attachment to a real asset class. Overall, it is a stretch to call volatility its own asset class. If you are talking about purely speculative transactions (“I am long volatility” or “I am short volatility”), it is really nothing more than legalized gambling. You may as well be betting on sports events.

Selling Short Volatility is a Disaster Waiting to Happen

Last week, I wrote about the collapse of VelocityShares Daily Inverse VIX Short-Term ETN (XIV), the inverse exchange-traded note issued by Credit Suisse (NYSE: CS) that tracked a short position in near-term VIX futures (which explains why the XIV ticker symbol was VIX spelled backwards). In only a month, XIV dropped 96% from 146.44 on January 11th to a final closing price of $6.04 on February 15th when Credit Suisse liquidated the ETN. The loss would have been 100% if the underlying VIX futures had doubled in value instead of increasing “only” 96%. That is how short selling works, selling something for a price of X results in total loss if the price increases to 2X or more:

Given the tremendous risk inherent in short selling, why was XIV such a popular investment? Why did one clueless writer characterize inverse volatility ETFs such as XIV as “The Best ETF of Our Time (AKA How to Become a Billionaire without Really Trying).” The answer is the frailty of human psychology. People are full of faulty investment biases that cause poor decisions resulting in loss. For example, this writer suffered from hindsight bias, where you take an isolated anecdote based on a low-probability event and erroneously generalize it into a lesson to be learned.

In the case of XIV, the worst-case scenario of volatility nearly doubling in a single day had never occurred, so investors convinced themselves that it never would happen. The result was that they blithely picked up pennies in front of a steamroller in the vain hope that the steamroller would never appear. People like to win the vast majority of the time and crave stability, a world without stress. The vast majority of the time, XIV provides stress-free investing, but frequency of success does NOT equal actual success if the few losers wipe out all of the prior gains.

All one had to do was read the prospectuses of the inverse volatility ETFs to know the truth, but nobody wanted to take the red pill. For example, the XIV prospectus stated:

In almost any potential scenario, the Closing Indicative Value of your ETNs is likely to be close to zero after 20 years.

In other words, the “black swan” event of volatility doubling in a single day and wiping you out is a virtually certainty at least once every 20 years. The fact that you may have made gobs of money with XIV for five consecutive years is completely irrelevant, and yet people took their past winning performance as indicative of the future because it felt so good to win.

Seeking Stability Causes Instability

The human quest to avoid any pain and instability has reached epidemic proportions. American economist Hyman Minsky recognized this human flaw a long time ago when he wrote that the human need for stability ironically creates the very foundation for future instability. The longer volatility remained low, the more addicted to the lack of volatility people became and they invested more and more money in inverse volatility ETFs that benefited from the low volatility. This increased investment made the future unwinding of the low-volatility trade all the more cataclysmic when volatility rose because all of the short-volatility bets had to be bought back in a massive short squeeze that caused VIX futures to soar.

Flaw of Averages

Statistician Nassim Nicholas Taleb laments the fact that investors often don’t understand what they are investing in. They are fooled by randomness and always neglect the possibility of a black swan event. They think that accurately forecasting future average volatility will save them even though the payoff function of their investment is not based on average volatility but on the effect of every single discrete instance of volatility. It reminds me of the “flaw of averages” where a six-foot person who knows that the average depth of a stream is only three feet decides to cross and subsequently drowns because he crossed the stream at a point where it was 10 feet deep.

Don’t Be Fragile

Taleb argues that investors have become soft and “fragile” in their quest to avoid uncertainty and loss with the result being that they end up suffering  much larger losses than would otherwise be the case if they could handle frequent small losses. In fact, Taleb’s ideal investors are “anti-fragile” in that they seek out disorder and risk but do so in an intelligent and limited way that ends up minimizing total loss and maximizing net profit. Fortune favors the bold as the old Latin proverb states, but only if boldness is performed prudently.

Be an Investor Who is Convex, not Concave

According to Taleb, another name for prudent boldness is “convex” investing where risks are frequent but strictly limited and gains are large. One should seek investments with asymmetric payoffs that favor profits over losses, but this requires the fortitude to accept small losses along the way. Convex investing lets you see your reflection clearly on the back of a spoon instead of looking at the world upside down from the concave front side. It also acts as a lens to converge your thoughts into laser-sharp focus, whereas concave investing disperses your thoughts away from each other in various chaotic opposite directions. A good example of a convex investor is Houndstooth Capital Management in Austin, Texas, which bet against XIV with put options and made a 6,000% profit while everybody else long XIV lost $2 billion.

“For a long time, this investment lost all its worth. Like any insurance, premiums feel like a drag. Until the day the insurance policy gets called on. For Houndstooth, each “premium” payment (options contract) cost around 87 cents. On Feb. 5, they were sold for more than $55.”

Most of the put options expired worthless for a total loss, but Houndstooth continued to buy the cheap puts knowing that one day they would pay off big time.

Buying put options is one of the best convex investment strategies in existence.

Buying Volatility is a Disaster That Happens Immediately

Since shorting volatility through the purchase of XIV is a sure-fire money-loser over the long term, does that mean that buying volatility through the purchase of a long volatility ETF will be a sure-fire winner?  

Definitely not! With volatility ETFs, you are destined to lose both ways, regardless of whether you go long or short. With short volatility ETFs, you lose your money all at once at the end after making small continuous gains initially, whereas with long volatility ETFs, you lose your money continuously from the get-go but experience a few profitable blips along the way that slow the decline but don’t reverse the decline.

Just look at the abysmal price performance of the ProShares long volatility ETFs over time (page 44):

End Date

VIXY
(unlevered)

UVXY
(levered)

December 2014

419.80

12575.00

December 2015

266.60

2835.00

March 2016

233.60

1933.00

December 2016

85.04

175.00

March 2017

52.68

64.68

 

The prices of long volatility ETFs go down continuously and by a large amount. Furthermore, the prospectuses of long volatility ETFs, just like the short volatility ETFs, warn that the expected value is zero over the long term.

Buying Put Options is an Anti-Fragile, Convex Investing Strategy

In conclusion, volatility ETFs are probably not a separate asset class, but with some option smarts you can still make money trading them. The best way to make money with volatility ETFs, long or short, is to buy long-term put options or put spreads on them and wait for their inevitable decline towards zero.


You might also enjoy…

 

Obscure Tax Law Forces This Company to Pay Out 90% of its Profits

A 50-year-old loophole is forcing one company to pay out $9 of every $10 it makes from ironclad contracts with the U.S. Government.

In fact, over the past seven years, it’s made payments ranging from a few dollars… to tens of thousands of dollars… 30 times. Without a single cut! 

Most folks don’t even know this company exists, but the ones that do are making a mint.

Like Ted B., who’s set to receive a check for $1,096 just a few days from now.

Merrill H., a 58-year-old from New York, has collected over $3,385 so far. 

And retirees Beth and Terry P. have raked in $16,555.

I’ve put together a special report that will give you all the details, including simple instructions on how to get your name on the payout list before the next cutoff date.

You can get your copy here.

Stock Talk

Pat C.

Pat C.

Very interesting. Love behavioral finance. One positive of recent volatility I think it has made me better able to tolerate small losses. It’s like poker. You can’t play if you can’t tolerate a loss. You don’t win all the time, but if you are smart and make your bets when the odds are in your favor you’ll increase your chances of a good outcome.

Add New Comment

You must be logged in to post to Stock Talk OR create an account