Spectacular drawdown levels in some popular volatility ETNs vindicate analysts who warned about the perils of the short volatility trade.
Many have warned about the bubble in short volatility trade using fundamental and technical analysis arguments. I have also done this in the context of trying to point out flaws in backtest results that some quants were using in support of these strategies.
When a trade gets crowded it implodes no matter how good backtests look. This is what happened to the short volatility trade but this time is interesting because it marked termination of XIV ETN after its NAV fell by more than 80%. Below is a drawdown chart of XIV.
No, this is not an error, the drawdown is 95% !!!
The financial industry but also regulators must get their act together. In recent times instruments have been designed with the only purpose of transferring wealth from the public to their designers. These include these volatility ETNs and weird things like cryptocurrencies and ICOs. The instruments are based on the same principles of offering hopes and dreams of quick riches to the public.
Of course, when something is public and offers wild dreams of easy money it gets crowded fast and then implodes. Those who conceived the scheme usually get away with it but they leave pain and destruction behind them.
As I wrote in a tweet yesterday, playing with volatility is like playing with fire. Volatility is fat-tailed and anyone who uses a strategy to exploit may face ruin as times passes. A sensible volatility strategy in my opinion is taking advantage of spikes via the use of positive convexity. This can be a long volatility calls but time decay costs money. There is no free lunch. Anyone who thinks there is free lunch at some point in time faces reality.
Below I have allowed free access to two premium articles for our subscribers last year where I showed that a typical volatility strategy has 75% probability of ruin among other things.
Below are links to two more articles I have written about the perils of volatility strategies:
If you have any questions or comments, happy to connect on Twitter: @mikeharrisNY
Charting and backtesting program: Amibroker
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