We have seen an influx of new products into the option and volatility markets for retail traders and investors. But these aren't really new products so much as a shift in availability.
Being able to trade volatility directly--or correlation, for that matter--is nothing new for hedge funds and other institutions, but it is new for the retail customer, especially one who avoids options. So it is no surprise that these products are a bit confusing to less experienced traders and investors, as they really aren't designed for them.
At the same time, however, some products are going the other way--strategies already available to us retailers getting wrapped up in institutional clothes and peddled in different guises. And it appears that these transmutations often end badly, at least for retail customers.
The perceived "failure" of the iPath S&P 500 VIX Short-Term Futures (VXX) exchange-traded note has been well documented. It has dropped to yet another new low today, falling to $33.45 from its beginning less than two years ago at $400 (adjusted for splits). But I stand ready to defend the VXX, at least to an extent.
One recent article from Fortune does present a good overview of the problems, though it includes such suggestions as "buy anything but the VXX" and "buy a put option and call it a day." These are the tamest of the comments involving these products, by the way.
I agree that there are some serious issues with the VXX, at least when the volatility term structure is in contango. But is just buying a put a better solution? This is a common suggestion, but it requires far more analysis.
Do you buy at the money or out of the money? Do you buy near term or six months out? And put buying is "path-dependent," meaning that your puts have less and less power to protect as stocks rise. So on both counts they require maintenance.
Now you may say the VXX has lost a lot of its value--the article says two-thirds (I guess for 2010 alone). But anyone buying puts would have lost ALL of their money--even with all of the work and analysis outlined.
So are you really better off buying those puts? After all, the VXX did double back in May when the S&P 500 slid 15 percent, so it was doing its appointed job.
On the other side of the coin we have "reverse convertibles". Never heard of those? Well, you must not have been among those lucky retail customers hit up by your friendly big bank to buy these wonderful investments that could pay out big bucks, even with the dreadfully low interest rates that we have seen. Reverse convertibles are "short-term bonds generally marketed to individuals that convert to stock if a company's share price plummets," according to Bloomberg.
Last June, for example, a reverse convertible was offered on Eastman Kodak three-month notes that paid 24 percent annualized interest but would require the purchase of EK shares if they fell below $3.54 from the then-price of $5.06. They did indeed fall below $3.50 less than three months later, and the bonds converted to stock.
Sound familiar? It should, because this is essentially the same as short puts.
Selling puts allows traders to collect premiums and takes losses only if shares fall below a certain level, at which point they are obligated to buy the stock. Big banks were charging outrageous fees for structuring these reverse-convertible deals and paying brokers handsomely to sell them.
If I tell you that you can make 24 percent on a bond and can only lose money if shares drop 30 percent, would you be interested? How about if I tell you I want to sell you a bunch of puts on EK?
The Bloomberg article says this trade ended in a loss, but EK was up around $6 at the end of 2010. So if those customers that had "been assigned" had simply held the stock, they would have ended up with a nice profit. But it is highly likely that they had no intention of buying the stock or wanting to own it.
And that is the catch of this strategy. Put selling can be a great way to collect premiums--even in low interest rate environments. Yet those doing so must be willing to buy the stock if assigned.
That mindset would have turned these losses into gains in the case of some of those reverse convertibles. However, the brokers selling them aren't likely concerned about that.
After all, they are salesmen and just want that commission.
(A version of this article appeared in optionMONSTER's Open Order newsletter of Jan. 12. Chart courtesy of tradeMONSTER.)