Repost: Nassim Taleb, Thanksgiving Turkeys, and Inverse VIX ETFs

*This will be the last repost, I promise - will no longer use the blogger app that keeps deleting this post*
We've documented here in the past the dangerous embedded in this current low volatility environment. If there is a volatility blow up, it is easy to imagine how easily things can snowball out of control. With that said, one of the areas not covered in minute detail is the prevalence of inverse VIX ETFs.
Before getting into that, here is some free promotion for Nassim Taleb's Fooled By Randomness and Black Swan books.
In one of the books (can't remember which one), Taleb pompously explains the simple concept pertaining the flaws of logic, the dangers of using specific incidences to reach general conclusions. One variant of this is using the past to predict the future. Amidst his grandiose and philosophically ridden text is quite a simple and down to earth example.

There is a turkey who is fed and taken care of until it is Thanksgiving time. If one was to chart the well-being of a turkey through this course of events, it would go something like so:

Now, when my parents heard I was trading my own money (back in undergrad...ah...those were the days), they frequently asked me whether I can lose everything in one day (they've heard the folktales and war stories of market-on-participant violence). I repeatedly said "No!".

Even during the most violent market crashes, there are a number of opportunities for non-institutional participants to get out. 1987 is the example of the most violent and immediate market crash I personally know. Even then, market participants with a nose for market timing had a few chances to exit the market with relatively mild losses or even be able to profit.

Then came 2017 and the prevalence of inverse VIX ETFs. Let's read a description excerpt from one of these bad boys.
 The investment seeks to replicate, net of expenses, the inverse of the daily performance of the S&P 500 VIX Short-Term Futures index. The index was designed to provide investors with exposure to one or more maturities of futures contracts on the VIX, which reflects implied volatility of the S&P 500 Index at various points along the volatility forward curve.

That statement brings up some intriguing questions:

What happens when, in one session, the VIX increases by 100% or more?
Has that happened? What happens to inverse VIX ETFs then?
What if the VIX increases by 50% or more - what happens to levered positions on inverse VIX ETFs? etc. etc.

First, has it happene
I looked at two different volatility gauges - the VIX directly and the older VXO (volatility for S&P 100) indicatively. Clearly, there is little that bounds these volatility gauges from appreciating upwards of 100% on a daily basis.

In fact, here are the times in history (of data available to me) when you would've gone bust holding these inverse VIX ETFs, if they existed in the past. I looked at both daily returns (prev day close vs next day close) and intraday returns (prev day close vs next day high).

I looked at scenarios with 0 leverage, 2x leverage and 3x leverage (believe it or not, I know of retail participants trading inverse VIX ETFs on leverage). I crunched some numbers and built a matrix with the 25 biggest return days in each scenario for each instrument. Times, when one would go bust, are in bold. Calculations are indicative as I am looking at spot VIX.

So yes, it's possible to go bust when these volatility gauges spikes, especially when levered.
What will those ETF instruments do when they should be down 100% or more?

From reading the prospectus it seems that an event of a spike in volatility occurs, it would be an "Acceleration Event" defined as:
  includes any event that adversely affects our ability to hedge or our rights in connection with the ETNs, including, but not limited to, if the Intraday Indicative Value is equal to or less than 20% of the prior day’s Closing Indicative Value.
where the manager of the ETF will liquidate its assets and proceeds distributed.

It's almost as if Nassim Taleb specifically built an instrument to illustrate his turkey concept.

What about the larger market impact?

From my digging, there seemed to upwards of 2.5 billion dollars invested in different VIX funds, mostly short vol in the form of XIV.

Although 2.5 billion dollar seems small in the grand scheme of an entire financial market. It is still a sizable amount held by retail that can potentially disappear into thin air.

Yield enhancement of a portfolio is all well and fine but there are ways to do it, and ways not to do it. There are also times to do it, and times when you shouldn't. Something to chew on.

I assume not too many Macro-Man readers are collecting nickels via these inverse VIX ETFs at this point of the market cycle. But if you are, congrats on the money you've piled up - and you should probably reduce positions to an amount you're okay with, if it evaporates in a day's time.

Portfolio Updates:
Short oil. There are a few tidbits regarding oil that has prompted me to cover Thursday. First Venezuela is a mess and there is the possibility that no oil comes out of the country. This is a concern for a short like me, as they are a huge global oil producer.
Additionally, higher US rates scare me as they can put meaningful pressure on US producers, which can lead to a reduction of supply.
Thirdly, the chart's just not cooperating for oil - seems to be making a bottom.
Lastly, perma-bull Andy Hall threw in the proverbial towel a week ago. I know it's anecdotal, but I think it speaks volumes regarding this market's sentiment.

Even if the oil market goes lower, there will probably be an easier time to go back short - when it feels less like I am fighting the market.

Short equities, we have seen the rally that I believed was in the cards - now will tech top out at this potentially lower high? I loaded up on an even bigger position Thursday. Will be either vindicated or stopped out within the next three sessions.
Long USDJPYUnlimited. Bond. Purchases. If JGB yields rise with the rest of the world's duration, then the BOJ has to buy more. The more the BOJ owns, the less liquidity that market will be and the more broken that market will become (just ask any bond trader).
A reflexive process can potentially take hold here: the weaker the Yen becomes, fewer participants who are not mandated to hold JGBs will want to own them (not to mention less liquidity in the market). The less they want to own them the more they will want to sell. The more they will sell means that the BOJ will have to print more Yen to buy JGBs and also coincidentally make JGBs less attractive vis-à-vis the currency and also killing the market's liquidity. 
So how much Yen will the BOJ have to print in order to buy an asset that most will not want to own? I don't know but probably a lot. Probably moar.
For all the commodity heads who follow the blog - look out for an upcoming softs post. Soft commodities, especially cocoa, are starting to look very interesting from the long side.

Thanks all, as always, good luck out there.
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Click here for comments
July 17, 2017 at 4:56 AM ×

A few quick thoughts while I am resting from a frantic vacation pace :)

Totally agree on crude (but a bit worried that so many here agree as well). I think it's time for XLE to fly above 50 dsma next week. Important to point out that despite so many predictions for crude to take a major dive it just holds the ground and refuses to fall any further than $43. You can pull up the continuous chart of WTI going back to the beginning of 2015, draw a line through $43, and quickly see that it serves as a solid support. Should it fail then I would have to revisit my bullish thesis. My year-end target on WTI is $60 (which is nuts at this point).

I think USD is tanking on Trump more than US econodata weakness now. Impeachment, incompetence, whatever... I am over that man, but think his troubles are not going to end anytime soon. So maybe USD takes out some major stops before real buying interest comes in. Very surprised to see it this low and I have been a DXY bull. This one really hurts.

I am growing increasingly bullish on XRT. This is a 180-degree turn for me and one I thought I would take later in the year. AMZN/WFM deal changed my view, culminated a washout, and added some basis to the idea that brick-and-mortar will not become extinct. Call them pick-up/drop-off/return sites, distribution centers, whatever, but while small items and non-perishable goods can be sold exclusively online many others can't and won't. Could go a bit more in detail when back from vacation but I like a few things I see from WMT (believe or not), and TGT may even be ready to fight its way up. Anyway, I am long XRT and think we could see $50 by year end on major short covering rally and more same-store-sales surprises from big chains (like the one we got from TGT).
Also, I think it's time to look at retail REITs here. KRG and KIM are building a base and just had consecutive closes above 50 dsma. There will probably be a short squeeze should both close above the mid-June swing high. $22.50 target on both.

Last thought... I think Nat Gas is about to fly much higher. Look at weather a few weeks to a month out. We are going to cook eggs on sidewalks. I think that shorts will absolutely crap their pants should the price close above $3.10 anytime soon. I added to CHK and established a pretty serious UNG long here. I will roll the futures as well but want to keep that small due to my low internet reception in the next month or so.

July 17, 2017 at 8:43 PM ×

Let's please not attribute more to Taleb than is his due. The turkey example comes from Bertrand Russell's critique of inductive reasoning in Problems of Philosophy.

“The man who has fed the chicken every day throughout its life at last wrings its neck instead, showing that more refined views as to the uniformity of nature would have been useful to the chicken.”. ― Bertrand Russell, The Problems of Philosophy

Macro Clown
July 19, 2017 at 9:47 PM ×

RE Charles: true true. Nassim Taleb is probably not much more than a pseudo intellectual who frequently quotes past philosophers. But as a reader of his books and a less accomplished philosophy myself, what does that say about me? 😭

Macro Clown
July 19, 2017 at 9:48 PM ×

philosophy reader myself**

Macro Clown
July 19, 2017 at 9:51 PM ×

Re: Johno

Interesting idea regarding XRT. I mean, talk about a contrarian idea. Jared Dillian over at the daily dirtnap (a very good newsletter) wrote a pretty interesting contrarian piece from the market sentiment perspective.

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