Why You Shouldn't Trade Volatility

by: David Fabian

Trader who is buying volatility futures is losing millions of dollars.

Other investors try to mimic these same results with volatility-linked ETFs.

The odds say that most of us aren’t fast enough or shrewd enough to make these types of trades worth the risk.

One of the top stories on CNBC today is about a trader who is relentlessly buying VIX futures despite millions in realized losses. No one can seem to figure out what the purpose of this play is other than the obvious lottery ticket event of a sharp jump in volatility in the S&P 500 Index.

I would normally read this type of article with the knowledge that this is probably a one-off kamikaze trader with more money than sense. Maybe they are some massive hedge fund with a sophisticated trading algorithm or a family office that is hedging some other unforeseen risk.

The fact is that there are a lot of similar traders and investors that try to mimic these "one in a million" shots all the time. How do I know that? There is $2.6 billion in just the top five volatility-linked ETFs and ETNs alone.

The iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA:VXX) is the largest and most well-known with $921 million under management. That doesn't count the billions in individual futures contracts, leverage, and options strategies that mimic a similar result.

The returns of VXX over the last five years are -98.58%. Barclays must continually reverse split the fund just to keep it from going to zero. Yet, strangely, it's assets always seem to hover right around a billion dollars. That means investors are continually throwing good money after bad to chase "the big one" even as time, costs, and performance work against them.

Imagine trying to time the next earthquake in California. You know it's going to come. It's virtually a guaranteed certainty. But can you stay solvent long enough to pick the exact day when it materializes? The evidence says no.

Traders with a betting mentality love to wager on fear in the hopes that a huge surge will override the natural inclination of the market to weed out this emotion. Even if the math works against them. Every now and then you can get lucky by being in the right spot at the right time to make some money on a fund like VXX. However, those events are outliers on the investment spectrum. Not the type of consistent returns that it takes to compound your wealth over time.

The best investors think in terms of probabilities that give them the best opportunities for long-term success. Betting against the market via volatility futures, short positions, bear market funds, or other negatively correlated assets have always been a losing proposition for all but the most disciplined and short-term traders.

The odds say that most of us aren't fast enough or shrewd enough to make these types of trades worth the risk.

Disclosure: I/we 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. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: David Fabian, FMD Capital Management, and/or clients may hold positions in the ETFs and mutual funds mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell, or hold securities.