Competitors would catch on and pile in flooding the market with supply, which pushes the price each company can charge for insurance down.
When the thing you are insuring against is a stock market crash, this is even more dangerous.
As more investors rush to supply stock market crash insurance, not only is each investor forced to charge a lower price, but also the risk that each investor takes on is increased.
That’s because by the time most investors are aware of this trade, the stock market will have already increased by a significant amount (the more the market goes up, the more VIX declines and VIX shorts profit).
So the stock market that investors are rushing to insure is more likely than not to be an overvalued one.
Additionally, each incremental investor that shorts the VIX also pushes the market up a bit more — as the price of crash insurance declines (a.
k.
a.
the cost of hedging), investors buy more stocks pushing up prices.
So investors shorting the VIX in a crowded market get hit by an invisible double whammy — their actions concurrently push up the risks they face while pushing down the expected return they can collect as compensation for taking on those risks.
This is a recipe for disaster.
And the sad thing is that FOMO (fear of missing out) causes investors to be oblivious to this danger.
Honestly, it’s hard not to FOMO when you see SVXY’s (and XIV’s which are pretty much the same) six month returns leading up to its implosion.
Unfortunately, this FOMO would cause many investors to lose almost everything.
The Six Months Before the Implosion (Source: Yahoo Finance)Losing EverythingLet’s review the situation we had on our hands as we headed towards February of 2018:There were tons of investors unknowingly trapped in an extremely crowded short VIX trade via ETFs, like XIV and SVXY, which because of strong historical performance had sucked up billions and billions of dollars.
The VIX was near all time lows, which meant that the price investors could charge for supplying market crash insurance was also near all time lows.
In markets, there is rarely a linear cause and effect.
Many times, seemingly insignificant events can, through a series of nonlinear and unanticipated relationships, trigger a market crash.
Prior to February 2018, stock markets had been so incredibly calm (and VIX so low) that even a small decline could cause investors to panic.
And that is exactly what happened — what should have been a routine decline in the S&P 500 caused the VIX (and VIX futures contracts) to shoot up like a rocket (rising almost 50% in just a few minutes).
This forced the managers of short VIX ETFs like XIV and SVXY to cover their shorts in order to cap their losses.
But what do you think happens when everyone simultaneously tries to escape through the same tiny door?The amount of bets that everyone was trying to escape was greater than the market could bear and thus each trade was executed at incrementally higher prices.
That is, each trade to cancel a short bet (equivalent to going long the VIX) had the painful effect of pushing VIX up even further.
And sensing the desperation of the ETF managers, traders on the opposite side, like sharks smelling blood in the water, were determined to extract their pound of flesh.
By the time everyone was done trading, the VIX had nearly doubled, and investors holding large short VIX positions had lost nearly everything.
Here are a few Reddit comments that highlight the damage and bitterness that this financial disaster left investors with:“I’ve lost 4million USD, 3 years worth of work, and other people’s money.
” — u/Lilkanna“I feel you as I’ve lost 1/2 of my net worth today T_T prob 5 years on my life” — u/asianhere“Is this right!???.Or some system glitch?” — u/cheapdvds“Correct me if I’m wrong but my biggest takeaway from the XIV debacle is that if I want to start a ponzi scheme and put a disclaimer that ‘you might lose everything’ then it will be okay right?.“— u/mauimikesLessons LearnedIt’s too easy to look back and say that shorting the VIX was a mistake.
Things always look obvious in retrospect but as they occur they are anything but.
However, there are still a few things we should keep in mind when we are confronted by investments that could be bubbles:If the price declines by 50%, will I be OK?.Don’t invest a significant percentage of your portfolio in highly volatile assets.
Liquidity.
Many of the worst crashes in financial markets occurred because the market suddenly dried up at the same time that everyone needed to sell.
When the majority of the crowd is on the same side of a popular trade, it’s time to honestly assess whether the market for that asset is deep enough to support a simultaneous stampede for the exits.
In financial markets, expected returns are your compensation for taking on market risk.
In other words, high expected returns protect you from the unexpected.
But when the crowd piles into your trade, expected returns go to zero at the same time that the probability of a major price decline increases.
So your protection goes away at the moment that you need it most.
Thanks for reading, best of luck, and cheers!More posts by me on investing and finance:Investing in Personal LoansThe Anatomy of a Stock Market DownturnDo Stocks Beat Cash?Do I have Enough Money to Retire?.