DGI Adventure 09-30-16 Choose the form of the Destructor – Shorting the Worst Stock Ever

If there was an investment vehicle that was specifically engineered to destroy equity in the name of mimicking the short term moves of a futures market, what would you do with that investment vehicle?

“Wait a second”, you might say. “There aren’t any investment vehicles that are engineered to destroy equity. That’s silly.”

Yes it may be silly, but trust me, it’s true.

Allow me to introduce you to UVXY, an ETF that is basically designed to lose money on purpose. It even says as much in the prospectus.

This is a real, honest to god ETF, with $665M in net assets and it trades on the NYSE with an average volume of 27M shares…

Just to illustrate its destructive power, when UVXY started trading, its split adjusted close on October 4, 2011 was $2,058,000/share. It closed yesterday at $18.00. That is a 99.999% loss in 4 years.

“Wait a second” you probably said. “Nothing opens trading at $2M per share. That’s silly.”

You’re right! That is silly, but trust me it’s true.

In the last 4 years, shares have undergone six (6) reverse splits, so the split adjusted performance is asymptotically reaching a 100% loss for eternity.

Yet as recently as two months ago, its inflows led all ETFs in the coverage universe of ETF Channel.

“Wait a second” you probably said. “This can’t be true. Who would buy shares of something like that? That’s silly. What is this thing?”

We’re starting to repeat ourselves, but yes, that is silly, and I have no idea who would buy this ETF. As for what it is, please read this very informative post on how UVXY works from sixfigureinvesting.com.

TL;DR version:

UVXY is designed to mimic the short term change in the VIX futures market. So the idea is that if the VIX of the VIX index jumps/drops, UVXY will also jump/drop. The UVXY jump/drop will roughly equal the jump/drop in the VIX itself.

It achieves this mimicking price action by using leverage to buy the nearest active expiration VIX of VIX futures contracts. Of course as those futures near expiration, it rolls its positions forward to the next expiry, which means it is selling short duration contracts in order to buy longer duration ones.

The longer duration contracts are almost always more expensive than the shorter duration ones. That’s because the amount of uncertainty (implied volatility) over the next two months is almost always greater than the amount of uncertainty over the next two days or weeks. So UVXY’s contracts suffer from the phenomenon known as contango.

The end result is that the day-to-day movements of the ETF’s price pretty closely mimic the day to day movements of the VIX, but over any extended period of time, contango completely erodes any value of the index’s “portfolio”.

So the TL;DR version of TL;DR version is the ETF takes bags of money, throws them in a dumpster and then lights the dumpster on fire.

So back to the original question…what does one do knowing that this kind of investment vehicle exists?

“Run away” is not a bad response.

“How can I short it?” is a much more greedy and opportunistic response.

The problem with selling it short is that when UVXY pops, it really pops. For example from September 8 to September 13, shares went from about $17 to $24 which is a 41% increase in a couple days. That is no bueno for a short. In that kind of environment, it can be very hard to borrow shares to cover the position. Your broker might close you out at exactly the wrong time, because dude, you are down 41% in a couple days.

In a really crazy period it might even hold onto those gains for a while. It will eventually resume its death march to zero, but maybe not for a while, and your broker probably doesn’t want to wait around to see if fyou can remain solvent longer than the market will remain irrational.

So the greedy investor that wants to short this weapon of capital destruction might look to buying puts. That is a “safe” way to short a stock, in that you put up the initial capital at risk, and that is your maximum loss. The further out into the future your puts are, the more likely you are to enjoy the death march price action. Fortunately there is a LEAPS market for UVXY, and you can buy puts that don’t expire until January of 2018.

At this point, a lot of credit is due the Financial Velociraptor, as I would never have been brave enough to try this trade without watching it work for him over the last year.

UVXY spiked up ~12% yesterday, so the price of puts was down. 

I put in a limit order to buy one put option with a $16 strike and a January 19, 2018 expiration for $9.85/share. The order executed, so I am now long a derivative that is short an ETF that uses leverage to buy long derivatives on a derivative of a ratio of derivatives.

Did you follow that? Yeah, I didn’t really either. I just pretend to know what I’m talking about.

Short story long (get it?), for this trade to pay off, I want the S&P500 to go up, stay flat, or only go down slightly over the next 16 months. I like my chances. Hopefully the UVXY decay curve is slightly faster than the time decay on the put option. Historically that hasn’t usually been an issue, but past results are not indicative of future success.

We’ll see.

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