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How to earn on a black swan?

15 Feb 2018,

Dear readers, let me come back to the interesting events of the past week, which literally brought a storm to calm waters of the financial markets and brought an unexpectedly high volatility to the financial world. To events that are to a certain extent extreme and respectful with regard to the speed at which they have managed to make from working funds and financial products only foggy memories.

I will probably repeat many times what has been said and written, so let me just remind you that there has been the biggest Dow Jones index spot loss in history and the VIX index recorded the biggest growth for its existence. All this you probably know.

In the Charles Bridge fund, we have repeatedly warned of such developments. But it is not enough to warn about the possible drops on the paper, it is mostly about taking action and preparing ourselves for such risks and adapting the trading strategies accordingly.


What happened on Monday, 5.2.2018?

During the Monday evening hours, popular and by many investors and hedge funds often traded instrument ETN: XIV practically stopped existing, ETF: SVXY managed to overcome its clinical death but on the fractions of its value from the previous week. Both of these instruments have one thing in common – they are based on market volatility decline, while massive intraday volatility rise is deadly for them.

We are also specialized in trading ETNs / ETFs in our fund, but I dare to say that we are quite different from most of the investors. While many traders have surely been tempted by almost continuous growth of these products (SVXY only in last year + 180%!), With monthly growth of 10%, our fund speculates on the opposite scenario – extreme volatility growth and the associated a drop in their prices.

We use long-term option positions – typically bear-call spreads, which were described in the previous article. These strategies are characterized by having a clearly defined risk-yield profile. So, if SVXY would have strengthened this year by tens or hundreds of percent, we know how much our maximum loss will be. This is, in fact, the basis of any investment – to keep the losses under control.

Many investors are wondering what led to such a massive and rapid fall in the price of these instruments. It is often said that algorithmic trading (automated trading systems) are the cause, but I see the main reason in investors’ greed together with certain blindness for possible major risks.


Thunder from the clear sky

The indices grew parabolically, and more and more investors were willing to take inadequate risks to earn a few percent for their annual performance. Billions of dollars a day began to flow to these products. The selfish indifference of other investors has begun to attract us, and we have created a relatively strong position that has focused just on the massive ETF and ETN problems coming from volatility and their construction. Simply said, these instruments inversely copy futures on the fear index VIX by 1:1 – it should work that if VIX weakens by 5% per day, SVXY will grow by 5% and vice versa. Surely you understand that if VIX volatility jumps by tens of percent (which is not a problem from extremely low values in recent months), then by the same percentage will instruments like SVXY be weakened.

On February 5, the VIX index grew by almost 80%. This is the moment when the ETF with a short volatility exposure must close all its positions in a very short time in order to protect its investors from losing more than 100% and thus moving the ETF value to the negative territory. These forced sales raised the volatility even higher and completed an extremely painful cycle that was close to panic moments. It is no wonder, therefore, that VIX has reached a level of up to 50 points, volatility has peaked, and many investors have erased their accounts.

Graf vývoje SVXY 5.-6.2.2018 (zdroj: TD Ameritrade)

Figure 1: SVXY development chart 5.-6.2.2018 (source: TD Ameritrade)


Hedge funds specialized in volatility shorting have typically experienced a drop of 30% or more on this day. You can read about the fall of LJM Partners: https://www.cnbc.com/2018/02/08/fund-crashes-after-wrong-way-volatility-trade.html

On this day, we managed to make almost half a million dollars purely at this black-swan stake while protecting the portfolios of our investors.


Lesson to learn…

Keep in mind that history has been repeated on February 5, 2018, and it is clear that it will be repeated again in the future. Instruments like ETN: XIV or ETF: SVXY are not the first or last products based on volatility shorting. There have been many products in the past that have been based on a similar principle and have ceased to operate after events of this type. However, banks have just renamed, re-branded and re-launched them.

Lesson taken from this situation is clear: these products need to be used reasonably and always with secured positions. Or, using them directly while creating expositions on black swans. We are trying to focus on this combination in the Charles Bridge fund and we search for a reasonable balance between risk and return.

For the next week I have prepared a small gift for you – the trading approach description of the “black-swan” strategy that we have used for SVXY. I believe you have something to look forward to.


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