Today I want to give you a tip to keep you out of trouble: never invest in something that you don't understand. That includes bitcoin, MLPs, annuities, structured products and even stocks. This may seem obvious but I have seen people make this simple mistake because they are chasing the hottest thing in the moment. Early in my career, it was internet stocks. People were buying companies with no earnings and no business plan and were simply interested because the price was going up. Years later, it was subprime loans. The worst quality mortgages were sliced and diced and then packaged as supposedly A rated bonds. When things are too good to be true and you can't understand how it is possible, trust your gut and run away as fast as possible.
Volatility products likely caused Monday's flash crash
On Monday, the Dow Jones Industrial Average fell over 1000 points or -4.5% on no substantial news. This was truly a bizarre event. Some are blaming volatility-related derivative products for causing the one day meltdown. This is another case of people who didn't understand what they were buying.
Last year, the popular trade was to short volatility and it worked well because it was one of the least volatile years on record. The VelocityShares Daily Inverse VIX ETN (XIV) was up more than 100%. There was even a story about a Target employee who turned $500,000 into $12 million by shorting the CBOE Volatility Index or VIX.
Well trends can change quickly and many investors were caught offside on Monday afternoon. Two of the hottest exchange-traded products (XIV and SVXY) designed to return the inverse of the VIX crashed and burned thanks to a massive spike in volatility. Their combined value shrank from $3 billion to $150 million in one day! While XIV is still trading, Credit Suisse announced that it will liquidate the product on February 21st. In a Reddit group, one XIV trader said, "I’ve lost $4 million, 3 years worth of work, and other people’s money" and even posted a screenshot of his entire portfolio in XIV.
In Japan, Nomura Holdings issued an apology after investors in a $300 million product betting on low volatility were all but wiped out when Nomura announced the exchange-traded note will be redeemed at a 96 percent discount.
In conclusion, never invest in something that you simply don't understand. There may be underlying risks that can wipe out your investment completely like these crazy leveraged volatility products.