Beware Potential New VIX Products

There’s news that new VIX trading products are on the horizon. I’d steer clear for a variety of of reasons.

First, as IndexUniverse points out, taxes.

Second — complexity and confusion. It’s pretty clear that the iPath ETNs are going to be based on VIX futures, which means you’ll be tracking the futures, not the VIX itself. As I’ve said before, and as Adam Warner succinctly points out, there is a big difference between the actual VIX and the futures that are based on it. If you aren’t aware of the trading behavior of VIX futures, don’t even bother with these. And if you don’t think it’s confusing, realize that even the writer and editors of IndexUniverse, who have nothing to do but write about index products, got it bass-ackwards. For in the third paragraph, they drop this little gem that perpetuates the myth that these things will actually track VIX, saying the ETNs ”will track the Chicago Board Options Exchange’s Volatility Index.” That’s simply not true. They’ll track the futures, and that’s a very important difference. Take my word for it.

Finally, these are ETNs, not ETFs. That too is an important difference, as Morningstar and IndexUniverse point out. You’re not buying something that actually has stuff in it. You’re buying an unsecured promissory note from a bank, and that bank promises to pay you some amount based on an index. Now the ETN will probably have VIX futures in it. But in reality, when you buy one of these things, you become an unsecured creditor of the bank. Barclays (BCS) stock is down in option price territory … less than $4.

In sum, you’re investing money into an unsecured promissory note, backed by a bank that is getting crushed. The note is far more confusing and complex than you probably realize, and the tax consequences are in flux.

Comments

[ETFexpert]

I agree and disagree----

What would you suggest as a replacement for a VOLATILITY play?
Selling market volatility by selling straddles? That could be riskier than this ETN, correct?

What will the Barclay's ETN correlation be to the item it is tracking? Better than 95% I'll wager to say......

Wouldn't the prudent financial advice be to wait and see how it performs and then cast judgment? If the truth were know, by the time a large corporation gets the "product" past thier legal department and compliance folks that particular "strategy-play" is over.

Ah-la the Merrill Lynch Focus 20 a copy of the Janus 20. If you have been in the game longer than a few weeks (as many folks around here seem not to have been) then you will remember that chasing the HOT-DOT isn't always the way to go.

Volatility plays are for the PROS and not the out of work (sorry, I have to bee honest here) turned "Day-Trader" The iShare gang will offer a nice ETN---primarily geared for the INSTITUTIONAL DESK.

My advice is to wait and see how the pros use it and then follow in with SMALL positions. Good luck....!!

2009 Jan 24 04:08 PM

[Don Fishback]

Hey ETF Expert, Don here.

Thanks for commenting. Before I answer your questions, I have a couple of questions back to you.

You talk about a 95% correlation between the ETN and the item it is tracking. My question is, "What do you think the item is that ETN actually tracks?"

My second question comes from your question that asks, "What would you suggest as a replacement for a volatility play?" Here's my question, "Do you actually think that the new VIX ETN will always represent a volatility play?"

Look forward to hearing your responses.

And as far as waiting and seeing how it performs, they've already posted the backtested data and disclosed the target benchmark, so we can make a preliminary assessment now.

One a completely different subject besides correlations, benchmarks and tracking, one easy assessment is that if you trade these ETNs, you're an unsecured creditor of Barclays!! Do you want your volatility bet to be dependent on the creditworthiness of a teetering bank?

-- Don

2009 Jan 25 09:15 AM

[Stephen Webb]

From different viewpoints, I think you both touch on the fact that a lot of unknowns exist with these new products and each investor should take precaution accordingly.

This includes being honest with their own level of sophistication and using products you firmly understand.

I'd also like to second ETF Expert's question and ask for other suggestions on alternative volatility plays.

2009 Jan 25 08:49 PM

[Don Fishback]

Hey Stephen, what you just said about being honest with one's level of sophistication could not be any more perfectly said. If you're not honest with yourself, you'll get destroyed. Maybe not immediately, but eventually.

As far as an alternative volatility play, isn't that the key question?

Here's the unfortunate answer. There is none, at least none that is easily accessible to the retail trader. Want proof. Think about this: If there was a pure play on volatility, don't you think they'd have launched that product by now? Instead, they're launching a product based on the futures. The reason is pretty simple. A product designed to be a pure play on volatility is almost impossible to create. Otherwise, don't you think someone would be offering it by now ... especially right now!!

I'll just tell you what I do. When volatility is this high, I sell in-the-money covered calls, out-of-the-money naked puts (secured by cash) and credit spreads.

-- Don

2009 Jan 26 09:25 AM