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Former Lehman Brothers Trader: Traders Shorting VIX Will Blow Themselves Up

Stock-Markets / Volatility Sep 06, 2017 - 05:56 AM GMT

By: John_Mauldin

Stock-Markets

BY JARED DILLIAN : The New York Times’ DealBook had a great piece of journalism a couple of days ago about short VIX carry monkeys. Well, that is what I call them.

The article features a former Target logistics manager who has goosed his net worth up to $12 million by betting that the VIX will go down. He is in the process of raising $100 million for a VIX-smashing hedge fund.


I probably had about 20 readers send me this article. They are very scornful of this guy.

Is it jealousy? Not really. People who understand the dynamics of these products know that it is the definition of picking up nickels in front of a steamroller.

About those nickels...

Risk/Reward

There are two types of trades:

  • You risk a little to make a lot.
  • You risk a lot to make a little.

In gambling terms, the former is “taking odds,” and the latter is “laying odds.”

In a casino, generally people don’t like laying odds. Take the craps table, for instance. All the action is on pass line bets and hardways, where you can risk a little to make a lot.

The casino is not the only place where people are scornful of laying odds. The stigma attached to risking a lot to make a little goes back to the release of Nassim Taleb’s second book, Fooled by Randomness, in the early 2000s.

It wasn’t as big as The Black Swan, but it was very influential in trading circles and got people to think twice about selling straddles and going to lunch.

Mathematically speaking, options are always a tad overpriced. So yes, it makes sense to sell them. But if you do it systematically, you run the risk of being exposed to a true black swan event—and getting carried out.

In the Face of the Biggest Black Swan

A curious aspect of all the VIX sellers smashing vol is the fact that they are doing so while staring down the biggest-ever potential black swan—nuclear war. If we attack North Korea, and it goes sideways, the VIX isn’t going to 20. It’s going to 100.

People know that deep down, but they think they will be able to “get out in time.”

That is the liquidity fallacy—whenever you put on a trade, you must accept that the liquidity that was present on the way in might not be present on the way out. You could be “stuck” short vol at 10 and watch helplessly as it reprices to 100. That’s a bankruptcy trade.

So, experienced traders know that this will come to a very ignominious end. But in the meantime, party on?

 “Something bad is going to happen sometime” is not an investment thesis, but it’s true. Something bad will happen sometime. Could be really bad.

If you’re a short VIX carry monkey, you are betting that nothing bad will happen, ever. That is verifiably a stupid trade.

But it has worked for a really long time. And to some extent, it is a self-fulfilling prophecy. If you go in and smash VIX after something bad happens, you make it not bad.

This happened recently when North Korea flew a missile over Japan. The VIX smash ensued, and stocks rallied back to unch.

It’s Not Sustainable

There was a paragraph or two in the Times article devoted to how complex (i.e., toxic) these products are, and how they are unsuitable for retail investors. I’d bet that most of these guys don’t know anything about option theory and haven’t heard of dynamic hedging. They only know that XIV goes up forever.

If this really does blow up, there is going to be some soul-searching at the SEC. If you securitize something really complicated and then apply leverage to it, of course people are going to trade it!

People will always find a way to blow themselves up—it’s just a lot harder with stocks and bonds.

Grab Jared Dillian’s Exclusive Special Report, Investing in the Age of the Everything Bubble

As a Wall Street veteran and former Lehman Brothers head of ETF trading, Jared Dillian has traded through two bear markets.

Now, he’s staking his reputation on a call that a downturn is coming. And soon.

In this special report, you will learn how to properly position your portfolio for the coming bloodbath. Claim your FREE copy now.

John Mauldin Archive

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