XIV – A Friendly Reminder

This past Tuesday, February 6th, one of the hottest trades for the past two years, the so-called easy money trade, blew up in a most spectacular fashion. After peaking around $145 halfway through January, XIV started to slide until it closed at $99 by the end of the day on Monday, February 5th. The next morning it opened just above $10, fell some more, then was liquidated by Credit Suisse.

If you had initiated the position at the start of 2016, when XIV was trading around $20, then by February 6th you had only lost 75 percent of your position by the end of the day. If you had waited until halfway through 2017 to start playing, then you lost 95 percent.

Kid Dynamite has the best explanation of what happened if you’re curious. Cullen Roche at Pragcap.com has the best quote from the XIV prospectus, which he notes that almost no one reads:

“The long term expected value of your ETNs is zero. If you hold your ETNs as a long term investment, it is likely that you will lose all or a substantial portion of your investment.”

The first thing that line in the prospectus tells you is that XIV is not a long-term investment to just buy and hold. It’s meant to be traded. However, even if you fully understood the product before you traded it there’s only three ways you could have protected yourself from the 90 percent gap down:

1. Buy OTM put options to limit losses. This isn’t a great option because the premium would severely eat into any trading gains to the point where generating positive expected value is questionable.

2. Position sizing: if you’re trading a derivative that has an asymmetric risk-return profile (e.g., the VIX was trading at sub-10 levels but could easily spike up to 30 or more, hence at least a 3 to 1 risk return profile), make sure the position size is small enough that the whole thing can go to zero without blowing up your account.

3. Don’t trade the derivative. Stick to trading assets that generate value by serving a widespread and reasonably useful purpose in society.

XIV is just the latest reminder of one of the truths of trading or investing: there are a lot of relatively easy ways to quickly make a little money but it is extremely hard to quickly make obscene amounts of money. When traders or investors try the latter, they often fail like XIV: in a most spectacular fashion.

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