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How short volatility products work? If you’re long volatility then you make money when the VIX index or the volatility index goes up. The opposite happens if you’re short volatility. When you’re short volatility, you make money when the VIX index goes down, and you lose money when the VIX index goes up. Vance Harwood provided a good explanation how XIV works here: XIV trades like a stock. It can be bought, sold, or sold short anytime the market is open, including pre-market and after-market time periods. With an average daily volume of 29 million shares, its liquidity is excellent and the bid/ask spreads are a penny. Unfortunately, XIV does not have options available for it. However, its Exchange Traded Fund (ETF) equivalent, ProShare’s SVXY does, with five weeks’ worth of Weeklys with strikes in 50 cent increments. Unlike stocks, owning XIV does not give you a share of a corporation. There are no sales, no quarterly reports, no profit/loss, no PE ratio, and no prospect of ever getting dividends. Forget about doing fundamental style analysis on XIV. While you’re at it forget about technical style analysis too, the price of XIV is not driven by its supply and demand—it is a small tail on the medium-sized VIX futures dog, which itself is dominated by SPX options (notional value > $100 billion). The value of XIV is set by the market, but it’s tied to the inverse of an index (S&P VIX Short-Term Futurestm) that manages a hypothetical portfolio of the two nearest to expiration VIX futures contracts. Every day the index specifies a new mix of VIX futures in that portfolio. This post has more information on how the index itself works. XIV makes lemonade out of lemons. The lemon in this case is an index S&P VIX Short-Term Futurestm that attempts to track the CBOE’s VIX® index—the market’s de facto volatility indicator. Unfortunately, it’s not possible to directly invest in the VIX, so the next best solution is to invest in VIX futures. This “next best” solution turns out to be truly horrible—with average losses of 5% per month. For more on the cause of these losses see “The Cost of Contango”. This situation sounds like a short sellers dream, but VIX futures occasionally go on a tear, turning the short sellers’ world into something Dante would appreciate. Most of the time (75% to 80%) XIV is a real money maker, and the rest of the time it is giving up much of its value in a few weeks—drawdowns of 80% are not unheard of. The chart below shows XIV from 2004 using simulated values. Understand that XIV does not implement a true short of its tracking index. Instead, it attempts to track the -1X inverse of the index on a daily basis and then rebalances investments at the end of each day. For a detailed example of what this rebalancing looks like see “How do Leveraged and Inverse ETFs Work?” There are some very good reasons for this rebalancing, for example, a true short can only produce at most a 100% gain and the leverage of a true short is rarely -1X (for more on this see “Ten Questions About Short Selling”. XIV, on the other hand, is up almost 200% since its inception and it faithfully delivers a daily move very close to -1X of its index. What happened on February 5? The Astonishing Story Behind XIV Collapse by Ophir Gottlieb provided a fascinating description of events leading to XIV collapse. The collapse was caused by huge increase in VIX index and forced liquidations caused by margin calls. Those liquidations triggered the Acceleration event, as outlined in the Prospectus: License to Print Money? XIV and SVXY were not bad products. The problem is not the product. The problem is how you use it. There is nothing wrong to maintain constant long exposure to XIV or SVXY. Over the long term, it is a winning strategy. Nowhere was the pain more palpable than on Reddit’s “Trade XIV” group, which counts more than 1,800 members. One of them goes by the cyber-handle Lilkanna, and to say he’s had a rough stretch would be a huge understatement. “I’ve lost $4 million, 3 years worth of work, and other people’s money,” he wrote in a post that’s garnering lots of attention. “Should I kill myself?” “I started with 50k from my time in the army and a small inheritance, grew it to 4 mill in 3 years of which 1.5 mill was capital I raised from investors who believed in me,” Lilkanna explained, adding that those “investors” were friends and family. “The amount of money I was making was ludicrous, could take out my folks and even extended family to nice dinners and stuff,” he wrote. “Was planning to get a nice apartment and car or take my parents on a holiday, but now that’s all gone.” The Problem? Leverage, Leverage, Leverage! When people make those kind of returns, it is pretty clear they are taking too much risk. Too much risk == too much leverage == position sizing too big. Imagine you make 10 trades. The first 8 trades make 40% each, and the last 2 trades lose 90% each. if you allocate 10% for each trade, your account is still up 14%. But if you allocated 50% of your account (not to mention 70-80%), your account is toast. This is what happened to those poor XIV traders. The problem is not limited to retail traders. We all remember the Karen Supertrader story. Those who are not familiar with the story: Karen The Supertrader: Myth Or Reality? Karen Supertrader: Too Good To Be True? How To Blow Up Your Account Here is another example. Mutual fund LJMIX, ran by Chicago based firm LJM Partners. They sell strangles on the S&P futures. This is their track record before this move: Excellent track record, but look what happened on Monday: And yesterday: Once again: The biggest problem is not the strategy. It is leverage. It is sad that even billion dollar hedge funds fall into the trap.

Whatever it was, the VIX went from 17% to 37% in a matter of two-hours, or up 115%. That is the largest percentage gain in the VIX in one day ever recorded. Even then, while that is a huge move, it wasn't really market disruptive in any great way other than, the market had a bad day. But then the after hours margin calls came in -- and that was an unmitigated disaster for one particular instrument of interest to us: Credit Suisse AG - VelocityShares Daily Inverse VIX Short Term ETN (NASDAQ:XIV). DON'T LISTEN TO TV The reporters on television have no understanding what XIV is -- it is not a naked short bet on VIX. No, it is an investment in the core underlying principle of market structures, driven by positive interest rates, known as Contango. Remember, the XIV is the opposite of VXX, and the expected value of VXX is zero. Here it is, from the actual VXX prospectus: This instrument is not a radical short trade, it is fundamentally an investment in an ETN that reverses the value of an investment that is ultimately expected to be zero, which made it so good, for so long, and would have for several more decades. WHEN A LINE BECOMES THE FOCUS A little detail in the prospectus of XIV is that, hypothetically, should it lose 80% of its value from the close, it would cause a "acceleration event." That means that if the XIV sunk to 20% of its value, it would go to zero and the ETN would go away (and start over later). Now, obviously, this had never happened to XIV before, but it's only a decade old. When scientists back-tested XIV all the way back to the 1987 crash and including the 9/11 terror attacks, they noted that even then, XIV would not have suffered a 80% decline in a day. But we have never seen such a market with so many naked short vol sellers as we have today. As a barometer, even as crazed as Monday was, here is how XIV closed: Down 14.32% is ugly, but, it's just a day -- a bad one, but nothing really all that crazed. Then the after hours session happened, and the best anyone can tell, as of this writing, is that some firm (or fund) had to unwind a short volatility position due to a margin call. That meant they had to buy the front month expiration of the VIX futures, leaving the second month unchanged. That little detail is everything, because the XIV is an investment on contango -- when the second month is priced higher than the first month. This is a market structure apparatus -- we could call it "normal market structure." But, with a flood of buying to cover short front month futures, the XIV started tumbling after hours. At first, social media saw it as a buying opportunity. Then it started dropping faster. Then disaster struck. The XIV dropped more than 80%: The financial press did its best to cover it, but after a 2 minute segment on CNBC, there was nothing left to say because of one major rule inside the XIV prospectus. Here it is: In that fine print, it reads that if the value of XIV dips to 20% of the closing value (if it is down 80%), the fund stops. That is, since this trade, if done with actual futures contracts, can actually go negative, the ETN stops itself out at a 80% one day loss. This is why we investors use the ETN, knowing that a 100% loss is the worst that can happen, as opposed to the futures, where much worse than 100% loss can occur. And the greatest burn of it all As of Tuesday morning the VIX is down huge (of course it is), the market structure has held (of course it did), and XIV would be having a very good day (of course it would). But, worse --- it turns out, as far as we know (still speculation), while it's hard to swallow, that the unwinding was done by none other than Credit Suisse itself. Yes, the creators of the ETN had another concern, beyond the assets under management -- and here it is -- -- look at the largest shareholder. Credit Suisse quietly became the single largest holder of the very instrument it created, and by a huge amount. So, as 4pm EST came around, a bad day in XIV, but survivable, became the death knell, because the largest holder, the XIV's custodian, panicked, and covered. But, Credit Suisse could not very well just sell millions of shares of XIV in a thinly traded after hours session, so it turned to the VIX futures market. It appears, as of this writing, that this has actually occurred. While Credit Suisse (the issuer of the ETN) has yet to comment, it appears that whatever this "flash crash" did, whatever margin calls were triggered after hours, the short vol trader was in fact the firm -- it unwound positions in a size that the market has never seen before, and that means that it looks like XIV is possibly going to some very, very low number -- like $0, low. It's with great regret that as of right now, we do believe XIV is, for all intents and purposes, gone, from a little rule hidden deep in the prospectus that no one gave much concern and that got blasted away when the top holder in the note was the custodian itself. It's a reminder that the real danger to a portfolio is not a bear market -- we recover from those quite nicely as a nation -- it's the delirium that happens when a bull market gets totally out of control and margin is used excessively in a spurt of just a few days. And by margin, we don't mean normal, everyday investors, we mean the institutions -- even the ones we entrust to be custodians of our investments. So that's it. XIV likely would have done just fine after this moment in time in the market, will not be given that opportunity to recover. It has been blown out on the heels of yet another Wall Street debacle, which no one seems to even understand, yet. The author is long shares of XIV in a family trust. Ophir Gottlieb is the CEO & Co-founder of Capital Market Laboratories. He contributes to Yahoo! Finance, CNNMoney, MarketWatch, Business Insider, and Reuters. This article was originally published here.

for those who trade VIX - be it though futures, options or ETP's (VXX,XIV,ZIV and the like). I came across a paper that I found very interesting - well I only glanced over it for now and read a few things in more detail, but it looks very interesting so far. Trading VIX related strategies is slightly more complicated in my opinion that 'normal' option strategies, so if you are new to options and still get your head around delta,gamma,theta keep this for later and certainly venture into this area slowly and carefully. Having said this I think this is written not overly complicated and you don't need a degree in maths to understand it. It also offers a number (5 to be precise) of actual trading strategies and compares them - so it's not only about theory. At the first glance I particularly like these two (for simplicity and results): #3-Roll Yield: if the 10 day moving average of VXV/VIX > 1 go long XIV else go long VXX #4-VRP: (volatility risk premium) if the 5 day moving average of (VIX - 10 day historical volatility) > 0 go long XIV else go long VXX I have heard of the first one before here (note this guy has the ratio the other way around). The results looks pretty good however I would caution that these reverse ETN's havent been around for too long yet (~2.5-3 yrs - so after the 2008 financial crisis) and trend in VIX was down over that time frame so a simply buy and hold would have been a pretty good investment as well. So the backtesting has to be seen in that context. A quick backtest since 30-Nov-10 (when XIV was listed) and I start with a long position in XIV on both: roll yield: 7(!) trades since inception, total (non compounded return (just adding % returns so +12%, +13%, -5% = +20%) = 296% (the strategy is long XIV since 12-Oct-11 without any trades since) VRP: 23 trades since inception, total return 153% buy and hold XIV since inception (30-Nov-10) 146% NB: I'm counting a flip from one ETN into the other as one trade. Backtesting has been done with EOD prices. I urge you to understand how VXX and XIV work and the risks involved before you actually try and trade this. Also read the paper (they mark the bits about risk with a 'grim reaper' ) okay here the paper and the link to the back testing sheet (let me know if you come across any errors). Marco. 00R_Easy Volatility Investing + Abstract - Tony Cooper.pdf https://dl.dropboxusercontent.com/u/26062189/XIV_VXX_strategies.xlsx