As everyone knows by now, $XIV, the inverse volatility ETN, blew up on Monday.  This was a function of short-term volatility surging after-hours.  The reasons for the massive spike in short-term volatility are unclear, and are not particularly important.  What matters is that it happened, and as a consequence $XIV blew up.

Unfortunately, I got caught in this product.  I purchased it earlier in the day and lost about 1.25% of my capital as a result.  This was a grave mistake.

I do not want the capital to go completely to waste, so I thought I would write down for the future what I learned from the experience.

1.        Never be too complacent about risk

Unlike some, I knew the risks associated with $XIV.  I knew that an 80% surge in short-term volatility could cause the redemption of the units or at the very least result in massive losses.  For some reason, I disregarded these risks.  

I underestimated the likelihood of such a spike in volatility over such a short period of time, probably because I had not seen it in the past.  I had seen massive spikes in volatility during the financial crisis in 2008/9, the Euro crisis in 2011 and the Asian crisis in 1998, but those spikes in volatility were less abrupt.  It took longer for things to escalate.  Volatility rose for a period of time before it ultimately spiked to its peak.  

By comparison, the VIX was trading under 10 less than just a couple of weeks ago.  The chart below shows just how fast the move up in volatility has been compared to past moves.  I think that I allowed the lack of much precedent and the fact that we had been in such a long period of tranquility to skew much perception of risk and therefore underestimate it.  It is important to always remain vigilant about risk, even, or maybe especially, during what appear to be low-risk periods.

2.        Avoid structured products

Again, I knew the risk that this product could vapourize, yet I bought it anyway.  There was simply no need, especially when all I was looking for was increased risk exposure.  I was betting on a move higher in equities through a complicated derivatives product with survival risk.  There was simply no need to get involved.   Key lesson is to avoid these complicated products.  You can make enough with simple ETFs without taking product risk.

3.        Have a firm stop loss, even if way lower

I normally do not trade with a hard stop although I am usually quite disciplined about taking losses.  For some reason, I watched $XIV essentially go from $90 to $20 in about 1 hour during after-hours trading.  For some inexplicable reason I didn’t sell.  I admit that I was stunned by what was happening, maybe frozen, but even at $60, for example, I should have realized that something bad was happening and I should have punched out for a loss.  I could have easily saved half my losses.  Having a hard stop in place (even at 50%) could have saved me some losses.

4.        Be careful around crowded trades

The short vol trade had become very crowded.  I knew that, yet I entered the trade and disregarded the risk that it might unwind rapidly, probably because I was only expecting to be in the trade for a few days or weeks and figured that it was unlikely that the unwind would catch me.  The lesson here is that when a trade is this crowded, it could unwind very quickly at anytime, so it is best to avoid such trades entirely or at the very least be extra vigilant about managing losses.

Thankfully, I only lost a little over 1% on this trade and so I will survive.  Hopefully, the lessons from the 1% loss will help me avoid or minimize future mistakes and losses.