Friday, August 12, 2011

The Fear Trade

This one is risky.

The markets are fearful and I am selling fear.

The link below explains the VIX, basically its a measure of how much market participants are prepared to pay for insurance against thier positions. When the markets are scared they pay more for protection. Right now there is a spike in the VIX.

VIX - The Wall Street Fear Gauge

XIV is an Exchange Traded Fund which is inverse the VIX - ie not only is it spelled the opposite way, but it also moves the opposite way. So with VIX at a peak, XIV has taken a battering, as VIX falls XIV should rise.

I took a position in XIV Wednesday, at one point it was 500 USD in the money, by the close it was out of the money for 240 USD at which point I sold not wanting to hold the position overnight.

After more research I again took a position in XIV on Thursday, this position is currently in the money for about 300 USD. I also added to the position at the open today. Right now the position is about flat.

The one thing that makes me comfortable with a large trade in XIV is that the VIX is really a measure of velocity and wherever the market eventually ends up the VIX always returns towards its mean value.

The charts above show how XIV has collapsed with the increase in volatility this week. As volatility returns to normal, XIV should almost double in value.

My two concerns with this trade are -

1) This week VIX peaked around 48, in 2008 the VIX hit 80, a surge to this level would wipe out 50% of the trade.

2) Tracking error. Its very difficult to construct a product that accurately tracks something as artificial as the 'Inverse VIX', even today VIX is down 6%, XIV has barely moved 1%.

3) Counter party risk. If this trade pays out a profit of 50% to 100%, someone somewhere is on the losing side of that. Can the loser afford to pay ? a lot of financial institutions will have been terribly beaten up this week.

Currently holding two positions, one initiated at 9.48, the second at 9.88

See the list of trades to the right for a link to XIV information.

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