If you've ever been to a County Fair, you've probably noticed dozens of bright-eyed children emptying their pockets into a machine known as the Coin Pusher. The Coin Pusher uses the same principles as the Claw Machine, only instead of stuffed animals, the prize is more quarters.
Here's how it works: Inside the machine is a horizontal bar that pushes the quarters closer and closer to the edge. The mark takes one look and can't believe his/her eyes. Why, there's a small fortune of overlapping quarters just waiting for one more push to come crashing down! What the mark doesn't realize is that three things are conspiring to rob him of his pocket change:
The 45-degree incline just above the drop is redistributing the mass of the quarters to the back of the machine, rather than the front.
The weight and engraved surfaces of the quarters increase friction and act as an anchor on the surrounding quarters.
Quarters are round, which means that the force of the pushing mechanism is distributed equally as linear motion is converted to rotational motion.
In terms of broken dreams, wealth erosion, and sheer, wanton cruelty, few financial products have equaled the Coin Pusher. One exception, of course, is the iPath S&P 500 VIX Short-Term Futures ETN. (NYSEARCA:VXX)
Like the Coin Pusher, the VXX is designed to empty your pockets by dangling the prospect of instant wealth in front of you. The idea is that bull markets contain their own correction: The higher the market goes, the lower the VIX ("Fear Index"), the lower the VIX, the greater the reward when fear returns to the market. While everyone else is running screaming for cover, you get stinking, filthy rich shorting the market. You can do it with very little money. The only real requirement is crisis, and there's no shortage of that.
But while shorting the market by leveraging the VXX is an intuitively attractive idea -especially given the roller coaster investors have been on for over a decade- it doesn't make financial sense to buy calls on the volatility ETF unless you're trying to hedge a bullish position.
The reason is the volatility products themselves. Here's the option chain for VXX Jan. '15 LEAPS.
(click to enlarge)
At first blush, this still seems like relatively cheap insurance. Unbelievably cheap, even: Who in their right mind would sell you a 16-month option on volatility?
Take a look below at the spike in VXX in 2012 alone: 1 year ago today (May 14th, 2012), VXX stood at $73.80. Yet, it was at $90.32 only two weeks later! For anyone lucky (or smart, take your pick) enough to pick up a few dozen short-dated calls in May, VXX brought a whole lot of early Christmases all at once.
iPath S&P 500 VIX ST Futures ETN Chart
(click to enlarge)
Okay: So, what's the catch? The catch is that VXX is designed to track the futures market, not the spot price, which means that if future expectations of volatility are greater than near-term expectations, you will lose money every month when the underlying VIX Futures are rolled over to the next month. The resulting erosion of wealth due to VXX since the financial crisis has been astounding.
When you think about it, that's exactly what you're assuming if you long VXX. You're betting that fear will return to the market sometime in the future. In effect, you're calling a simultaneous top on the market and bottom on volatility. Meanwhile, while you're waiting for T.E.O.L.A.W.K.I., your position is taking a hit again, and again, and again.
In other words, unless you're a) making a short-term bet on volatility itself or b) looking for a short-term hedge for an aggressive growth portfolio (read: insurance), going long VXX whether directly or through options is an incredibly risky (and expensive) strategy.
VXX is the Wall Street equivalent of the Coin Pusher: a financial windfall that's just inches away, yet somehow always out of reach. It's not an accident. VXX is designed to lure investors in with the promise of a "can't lose" scenario. The reality is that VXX can't seem to win for losing:
- If future volatility is lower than it is at present, you will lose money.
- If future volatility is higher than it is at present, you will lose money.
- If volatility remains the same, you will lose money.
In fact, the only way to win with VXX is to hit a grand slam home run by predicting a market top and a volatility bottom simultaneously. But what couldn't you make money on with that kind of a priori knowledge?
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.