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I'll say it loud, I'm a VIX short and proud. Short VIX products such as ProShares Short VIX Short-Term Futures ETF (NYSEARCA:SVXY) or VelocityShares Daily Inverse VIX Short-Term ETN (NASDAQ:XIV), or puts on long VIX products such as iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA:VXX) or Ultra VIX Short-Term Futures ETF (NYSEARCA:UVXY) seem like a great bet. The mean-reverting nature of the VIX coupled with the fact that VIX futures are usually in contango mean that a short VIX strategy will probably deliver outstanding returns into the future.

Printing Money

This is not to say that short VIX positions are not without risk. SA writer Macro Investor sums up the basic risk-reward proposition of short VIX positions well here. Here's MI's argument boiled down to a two-sentence summary: short VIX positions have produced mammoth annual returns since VIX futures trading began in 2004 despite the 2008 financial crisis and subsequent market panics. However, drawdowns have been as high as 90%, so VIX shorts need to have nerves of steel to make it through those rough patches to realize riches.

I agree with this story. And as far as I can tell, most of the "smart money" is net short, leaving it to starry-eyed retail customers, lumbering, volatility-averse institutional investors, or VIX options market makers seeking to hedge to take the long side of the bet.

Hidden Risks

The problem is that if "everybody knows" that something is a no-brainer, then there are often hidden risks that are unknown or under-appreciated. I've been racking my brain trying to figure out what I might be missing here. In other words, are there any worst-case scenarios that VIX shorts assume are impossible that are actually only improbable?

Here's one: the price of VIX futures increases by 100% within a given trading day. If this happened, then all bets are off and the short VIX trade changes from being a genius strategy to a weapon of mass wealth destruction. Here's what could happen, according to the prospectus of my favorite short VIX product, SVXY:

The use of leveraged positions could result in the total loss of an investor's investment.

That loss would happen because in an inverse product like SVXY, a 100%+ daily increase in the underlying futures positions would cause the fund's NAV to go to zero and the fund would be forced to liquidate. Without capital or a plan to immediately re-enter an extremely turbulent market, VIX shorts would see their investment totally dissolve.

Black Swans

In my mind, this type of black swan event should be the risk that keeps VIX shorts up at night. Note that I draw a distinction here between a large drawdown experienced by a short VIX strategy in 2008 or 2011 and the sort of flash crash experienced in 1987 and 2010. It is not a bear market that should be most feared, but rather a temporary yet severe market dislocation. The former is typically driven by deteriorating sentiment and economic conditions, the latter by a hitherto unknown flaw in market structure.

At this point, such worrying may seem like much ado about nothing. The VIX futures market functioned properly during the 2008 crisis and appears to be resilient and liquid. I believe that part of the reason for this resilience is the fact that VIX futures are traded in a relatively transparent fashion on a regulated exchange. Open interest in the market has been growing like gangbusters:

(click to enlarge)

A Sociology of Derivatives Markets

But this rapid expansion and apparent security is exactly the point. It is precisely those markets that are new, untried, but seemingly secure that are the most vulnerable to black swan events that reveal holes in market structure. As sociologists would say, the institutional basis of the market (legal framework, an established set of rules-of-thumb or best practices among participants, clear participant understanding of a products' quirks, etc) is still shaky may be unable to support an orderly market during a period of stress.

A great example of this shaky institutional basis is the development of options and index futures markets and the subsequent crash of 1987. In 1973, the Options Clearing Corporation was established, allowing for investors to trade options on single stocks over a public exchange. As this experiment proved a success and regulators became more indulgent, public derivatives exchanges proliferated.

Two of the most important products developed in these early years were stock index futures in 1982 and index options in 1983. Now with options and futures to trade alongside the equity indices, arbitrageurs and portfolio strategists had a field day. There were so many new ways to hedge risk or find arbitrage opportunities across these different product classes. And as the 1980s bull market started to roar, everything looked peachy.

The problem is that some of these new strategies devised to maneuver between stock indices and derivatives based on those indices dramatically changed the structure of the market. One notable example was portfolio insurance, which often relied on short index futures positions to offset long equity portfolios during falling markets. And while this sort of momentum-based hedging strategy seems innocent enough, if it gains a sufficient following it can lead to cascades of sell orders as small declines snowball into market routs. Such a rout is exactly what happened on October 19, 1987 as market makers were overwhelmed with sell orders and the capital markets went off the rails.

Since that time, additional legal and institutional safeguards along with the wisdom of market veterans have helped protect index options and index futures from experiencing another meltdown. These products have undergone their trial by fire and have come out the other side all the more resilient.

Stress Points in the VIX Markets

So where are the potential stress points in the VIX markets? Black swans typically come out of nowhere, so it may be a fool's errand trying to foresee how the VIX futures market might size up. But if I had to guess, I'd say that VIX ETNs like VXX are the perfect contagion mechanism. Not only are these instruments exposed to the credit risk of the issuing institution, but issuers are under no obligation to hold the underlying index constituents. I believe that issuers do probably hedge their exposure to some degree, but may turn to over-the-counter derivatives for this purpose.

This sort of arrangement linking liquid and transparent markets with illiquid and opaque markets recalls ominous precedents. The housing crisis turned into a generalized financial crisis because the broad and liquid market for mortgage-backed securities became linked to illiquid over-the-counter derivatives such as CDOs or CDSs. Now I don't believe that VIX traders will cause the next crisis, but it is sobering to think about the extent to which VIX markets might resemble an iceberg: they are only partly visible and the larger, invisible parts are precisely those that will sink your portfolio.

Rules for VIX Shorts

Despite all this worrying, I still think that the short VIX trade is a winner in the long run. So traders should still push ahead, but incorporate into their strategy the real but unquantifiable possibility that short VIX ETPs may go to zero and be liquidated, perhaps as often as once a generation. So here's some rules I've developed to mitigate the damage in the event of such a disaster:

1.) Don't Be Greedy- No matter how good the short VIX trade looks, never, never bet the house on it. Whereas the stock market is unlikely to go to zero in the absence of a nuclear holocaust or revolution, I'm not as confident about VIX futures ETPs. So only devote money to volatility trading that you could live without. Regularly rebalance your winnings to other strategies that might have lower payoffs but less liquidation risk.

2.) Have some sort of "Nuclear Meltdown" Plan- Manage your VIX positions so that if the unthinkable does happen, the damage is limited. One possibility is to have a long VIX hedge such as UVXY, perhaps 10%-20% of your short position. Such a hedge may be a drag on gains, although an argument can be made that it actually improves performance. Another is to trade options on SVXY (I like LEAPS) so that less capital is required to obtain the desired level of exposure. If the market goes haywire, you lose less than you would have with an outright SVXY position.

Be Afraid, Be Very Afraid

I hope that this article has been scary to some of you out in vixland. The most dangerous markets are those whose participants are complacent. Hopefully the worst-case scenario will never happen and this worrying is unnecessary. But just in case, I'd recommend taking the adequate precautions. Sure, you may lose the chance at that second yacht, but you will lower the risk of having to eat dog food in your old age.

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.

Source: The Risk That Should Keep VIX Shorts Up At Night