Misadventures in Volatility


When the stock market fell 10% recently the biggest losers weren’t stock investors but rather volatility sellers.  Stock investors can’t be seriously harmed by a simple correction.  Even aggressive, margined investors can survive a 10% decline.  Brokers are smart enough not to make margin loans that become potentially uncollectible in the event of a run-of-the-mill correction.

To repeat myself, there is nothing unusual about market corrections.  That doesn’t mean they can’t hurt people, but getting into exceptional trouble under unexceptional circumstances requires a certain creativity.  Enter volatility trading.  In the modern financial world, it is possible to bet on stock volatility as if it were a physical commodity.  Just as a trader can buy gold anticipating inflation, a trader can also buy volatility anticipating market gyrations.  Here is a good place to find some mischief.

In theory, volatility trading serves an economically, and one might say socially, useful purpose by giving investors a novel way to slice and re-divide risk amongst each other.  That theoretical value may not actually translate to real-world value, but whether volatility trading is inherently “good” or “bad” is beside the point for the purposes of this piece.

Volatility can be traded just like pork bellies or gold, and sure enough, people go ahead and trade it.  You can trade money for it and hope to trade it back for more money later.  You can bet money that it will go down and try to profit that way.  So let’s ask the first question: what is the nature of volatility as an asset?  How much does it typically fluctuate?  Intuitively, one would think that since stocks are inherently quite volatile, volatility would have a fairly consistent value—stocks remain stocks, after all.  This intuition hasn’t been borne out in the market, however, not lately.  During the stock market’s long, relentless upward march, measured volatility mostly went lower and lower.  It showed a little life in late 2015 and early 2016, then spiked again briefly around the 2016 elections, but throughout 2017 volatility traded down to unprecedented low levels. Logically, the sellers of volatility were the ones making money.  Predictably, many of them looked for ways to make more money faster.

Seek and you shall find.  Along came exchange traded funds (ETFs) and exchange traded notes (ETNs) that allowed anybody with a brokerage account to buy or sell volatility, with leverage.  The leverage didn’t even require a margin agreement, it was simply baked into the product itself.  These products made leveraged volatility just as easy to buy, sell, or day trade for that matter, as stocks or index funds.

So lots of traders piled into the short volatility trade because it was working, using lots of leverage, and the trade worked great until it didn’t anymore.  When the market corrected in late January and early February, the volatility index (VIX) rose from a low of 11 to a high of 50.  The anti-volatility products completely blew up, losing more than 90% of their value in numerous cases.

One unfortunate, high-profile investor named Howard Lindzon who blogs about his trading adventures at howardlindzon.com got caught shorting volatility.  He blogged that he lost most of the money in one of his accounts, a “smaller” account that he uses for unusual trades (good idea!).  His case was particularly sad, arguably unfair even, because he shorted volatility after it had already spiked, but the short volatility ETN he purchased had failed to reflect the lower underlying price of volatility, so the price he paid was much too high compared to the underlying market.  He paid what is commonly called a “stale price.”  Then he bought more as the price moved against him, thinking he was getting a better deal.  There is a joke about a gambler who loses half his money betting on a single football play then loses the other half betting on the instant replay.  Lindzon’s investment declined about 95%, quite possibly 100% because his blog post seemed to imply he used margin.

When I first read his blog post about what happened, I was aghast that an experienced, intelligent trader could be so stupid.  On some reflection, I have more sympathy.  And I think there are a lot of valuable lessons packed into what happened.  I’ll start by quoting Lindzon’s main takeaway:

“The real lesson is to use actual futures and options directly when you want to trade volatility and not some lame product put together by marketing departments of banks and fund providers.”

I couldn’t say it better.  Good for him.  He was led down the garden path to his account’s demise, and, to his credit, he realized his mistake and drew the right conclusion.  Mistakes happen.  The trick is not to repeat them.

There is a more fundamental lesson, however, that I think Lindzon might be missing: don’t get involved in trades you can’t understand.  Lots of people are guilty of this.  Almost nobody understands how volatility is measured, packaged, and traded, especially when you add the extra complexity of an ETN on top of it, but lots of people trade it anyway because they think it is an easy way to make money.  They all deserve what is coming to them.

Like I said, mistakes happen.  We don’t always know what we don’t know.  We’ve all gotten ourselves into situations we later realized we weren’t prepared for, perhaps while traveling or by trying to take a class beyond our depth in a subject.  However, before we plow our hard-earned savings into a financial security, we really ought to get our heads totally around it first.

Try to approach investing with what I would call a healthy paranoia.  Athletes often prepare for a contest by visualizing success, but visualizing failure might be more useful for investors. Ask what could go wrong?  Can we live with that outcome?  How likely is it?  If we can’t see how things could go wrong, then that should be a huge red flag.

The best cure for a general lack of awareness about investments is to study the mechanics and details of how those investments work, not just getting comfortable with the broad-brush concepts and overarching forces at play.  Don’t be satisfied just getting the gist of things.  This is the kind of “good enough” lazy grasp that gets folks blown up in short-term volatility ETNs trading at stale prices.  There is an aspect of self-discipline required to study the details of things, and an aspect of self-denial required to avoiding situations where you haven’t studied the landscape sufficiently.

Some people may scoff that self-discipline and self-denial have fled from our culture.  I don’t think so.  They are profitable concepts, and everybody is always looking for those!

By the way, Lindzon plans to sue Credit Suisse, the ETN’s sponsor.  I guess I wish him luck.  I’m not sure how much hope I would hold out though.  How do you prove you’ve been cheated when you can’t explain the rules of the game yourself?

Miles Putnam, CFA