Short Vol ETFs wiped out today (investments)

[BWV]

https://www.thebeartrapsreport.com/blog/2018/02/05/the-mechanics-of-the-short-volatility-explosion/

Hope none of you all were playing around with these. XIV had a 5 year annualized return of 43% as of year-end and about $2 billion in assets but is likely a complete wipeout. When you are 100% short something that goes up 115% in one day, the results are not good. The day’s return on XIV only shows a 14% decline but the fund will likley be liquidated tomorrow at a complete loss. The fund shorted volatility, which is kind of like selling hurricane insurance - you can make good money as long as there is not a storm

 

[BWV]

Bloomberg did a good piece on the subject today

https://www.bloomberg.com/news/arti...-inside-wall-street-s-8-billion-vix-time-bomb

 

[phyzguy]

Well, I guess some people are learning that when you gamble, you sometimes lose.

 

[Vanadium 50]

Well, if XIV is part of a carefully-thought out risk-management strategy, the fact that one component has essentially "railed" should be no big deal. More of a feature than a bug.

If on the other hand, it was purchased speculatively, sometimes when you gamble, you lose. No sympathy here.

PS I see phyzguy beat me to it.

 

[BWV]

I have some empathy for any unsophisticated retail investors who were in these, but it is also an interesting phenomenon. A prescient paper from last November:

https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3071457

 

[Vanadium 50]

I have some empathy for any unsophisticated retail investors who were in these

Why? If you are an unsophisticated retail investor, why are you buying a derivative of a derivative? I would argue that in this case, you're not investing. You're just gambling.

 

[BWV]

Why? If you are an unsophisticated retail investor, why are you buying a derivative of a derivative? I would argue that in this case, you're not investing. You're just gambling.

what, you don't have any empathy for this guy?

http://www.businessinsider.com/form...llionaire-using-short-volatility-trade-2017-8

 

[StoneTemplePython]

Why? If you are an unsophisticated retail investor, why are you buying a derivative of a derivative?

Barring the case where the unsophisticated investor is there purely based on advice of an 'adviser' I completely agree. In general they have zero business being anywhere near plain vanilla derivatives let alone something like this. (There are a lot of agency problems on the "advice" side but that's a different thread.)

 

[Vanadium 50]

what, you don't have any empathy for this guy?

No more and no less than someone who bought a winning lottery ticket. (And he made millions, so it's not clear why I should be empathic towards him)

 

[BWV]

(And he made millions, so it's not clear why I should be empathic towards him)

I was kidding

 

[Vanadium 50]

Well, if XIV is part of a carefully-thought out risk-management strategy

Elsewhere I was asked "how can this be?"

Here's how. Suppose you had two stocks, A and B, and you expect them to move in opposite directions. Say they each cost $100/share and you have 100 shares each. You want to keep half your money in one and half in the other. The next say, A moves to $101 and B to $99. So you sell 1 share of A and buy 1.01 shares of B with that money, and you're now at 50-50 again. The next day, they both move back to $100, and your portfolio is now worth $20,001. This dollar you just made is called diversification return.

It should be obvious that the more volatile the market is, the more the diversification return will be. It's as if you had a small investment in VIX. If that feature is undesirable, you can counteract or "hedge" it by investing in XIV (or instruments with similar behavior like SVXY). That will give you more stability in your portfolio's values, with lower highs and higher lows.

 

[BWV]

Except it doesn’t work like that. A long vol position requires a long option position and assuming theta (the time decay that causes option prIces to decline as maturity approaches). This, simplistically, is why the long vol etfs have lost 90% of their value in the four of five years since they were launched. The short vol etfs are selling options so they make money from theta except when vol spikes, increasing the value of the short option position. There is no free lunch - in an reasonably efficient market no portfolio hedging scheme should give you a better payoff than some combination of stocks and cash. Negative correlation to the market must also mean a negative expected return so that any derivative position gives you no more expected value than ‘stocks plus cash’ portfolio. If this was not the case, there would be riskless arbitrage opportunities, and in finance the absence of arbitrage is the equivalent of the conservation of energy - i.e. any free lunch investment scheme is as credible as a perpetual motion machine

 

[Vanadium 50]

I don't think I ever said XIV is a free lunch. If you mean diversification return, that's a real thing. See https://arxiv.org/abs/1109.1256 But it's not necessary to my argument that this be an effective strategy. My point is that people do diversify and rebalance their portfolios and in doing so effectively invest in volatility. If this is undesirable, they can add some "amti-volitility" to the mix.

 

[BWV]

Except that vol is not an asset, it is a zero sum derivative position. There is a short vol risk premium because of the desirability of long vol as a portfolio hedge, i.e. the fact that losses in short vol are correlated with negative market returns. The net of short and long vol is of course zero.