Monday, August 13, 2012

Lesson 15: VXX Stay away from what you don't understand

A little while ago, I made a few small trades in VXX. A friend of mine wanted to buy it, thinking that the whole Greece and Europe thing would cause an increase in volatility. This seemed like a pretty valid guess. It's not a trade that I would normally do under my principles, but just for fun, I wanted to do a very small position as well. However, when I opened up the prospectus,
 I felt more iffy. VXX was an ETN. I wasn't really sure what an ETN (Exchange Traded Note) was, but basically, it was kinda like an ETF (Exchange Traded Fund). They were similar in that they traded like stocks on an exchange, but it was different in that the ETN had no underlying assets.

In the prospectus, VXX was offered to investors as a bond. Barclay's, which was the underwriter, would receive the money up front. Upon some maturity date, Barclay's would redeem the current value of VXX to the investor. Instantly, there were two things I noticed. Since there were no underlying assets, VXX was not collateralized. At maturity, you were paid according to the credit and good faith of Barclay's. You were buying into Barclay's credit risk. Second, Barclay's is effectively shorting the volatility index. This is an enormous short position for Barclay's. Now, maybe it was hedged in some way. But hedging costs money. It is not easy for Barclay's to have a fully hedge position and still earn a profit.

This was very fishy to me. I did not really understand ETN's, and I did not understand why Barclay's was doing this. VXX had also seen an enormous drop since 2009. Part of me thought this was a bit justified since volatility has been dropping. The silly part of me felt that VXX at such a low price has enormous upside potential. Ultimately, to satisfy the gambler inside me voiced its opinion, and I shorted a small number of puts at short term expirations. I pocketed a tiny profit and decided that maybe I shouldn't trade it anymore. I didn't really understand why VXX had dropped so much and not recovered.

Months later, (now) I see that VXX has dropped an even larger amount of its value. All of a sudden, I came across an article explaining VXX and everything became clear. VXX tracked some short term futures of the VIX. At ever expiration date, money was rolled into the next future. Each time the roll happens, money is lost. VXX was designed to drop to 0 simply due to the rolling of the futures. Now, everything made sense. Since VXX is designed to eventually hit 0, Barclay's has no incentive to have any underlying assets. It now made perfect sense that Barclay's would take an uncovered short position.

In other words, VXX was intended for suckers. The biggest suckers were the ones who bought during the initial offering. VXX was a product which was designed to hit rock bottom and sap any money from ignorant investors. Even though I made a small amount of money, I was still a sucker to buy into it. I am a lucky sucker in that I realized that something was probably wrong, and the potential for VXX to make some miraculous climb was probably not there.

Recently, I've had a new thought. Perhaps I could short or purchase long term puts on products like these. If the product is designed to hit rock bottom, the odds should be heavily in my favor to be bearish on it.

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