The Dangers Of Volatility Trading

Posted: Feb. 9, 2018, 10:52 a.m. by

Volatility Trading


Volatility is a measure of the uncertainty or risk related to changes in the value of a security. High volatility suggests the value of the security will be wider (both positive and negative) and low volatility indicates the value will change at a steadier pace over time.

Volatility trading describes the act of investing in the volatility of the price of a security instead of the underlying price of the security itself. If it sounds complicated, it is. It is also dangerous. In fact, some have warned that trading in the popular XIV exchange-traded note might be the “most dangerous trade in the world.”

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Betting On Low Volatility

The XIV is a way to bet on low volatility. Volatility is measured by the VIX, a ticker symbol for the Chicago Board Options Exchange (CBOE) Volatility Index. The VIX itself is a computed index based on the volatility of S&P 500 options. A VIX below 20 is considered low and one above 30 is considered high.

When volatility is low, as it has been until recently, investing in a product like the XIV can be profitable. When volatility is high (Thursday’s VIX was 33.46, up 21% on the day), that’s when things can go south quickly.

The Problem

If you were to buy all the stocks in the S&P 500 in the correct proportions, you would end up with a portfolio that would perform similar to that index. There is, however, no direct way to buy products tracked by the VIX.

The creation of VIX futures precipitated the creation of VIX-related exchange-traded products. The best known of these is the VXX. The VXX is considered a poor long-term bet by many due to the way futures are structured and how that affects the VIX. Basically, the VXX strives to provide continual exposure to 30-day futures on the VIX. Since those futures expire every month, the managers of the VXX continuously sell less expensive soon-to-expire VIX futures to buy more expensive longer-to-expire ones.

Enter The XIV

Since the XIV is designed to inversely perform the VIX, in times of low volatility, theoretically it solves the VXX problem. But only in times of low volatility. That’s because the XIV is continually buying back cheaper soon-to-expire VIX contracts to short more-expensive longer dated VIX futures.

Recent volatility in the market has caused products like the XIV to cost investors dearly. Part of the reason for this, at least with inexperienced investors, is that they are unsure about whether they are betting on high volatility or low volatility. Even when they know, if the market goes contrary to the way they expected, they lose. In short, they are betting on both near-term and long-term volatility, something nobody can see coming.

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File Under High Risk

It was junk bonds in the 80s, dot-coms in the 90s and subprime-mortgage bonds in the 00s. The one thing all those investments have with volatility plays today is the fact that they are/were considerable risk and not well understood by retail investors.

Volatility-based plays are especially risky because uninformed investors often fail to realize they must frequently renew their futures contracts, at great cost, to stay ahead in the game. A better play for many may be not to play at all and stick with what you know.