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Why You Must Be Careful Trading Volatility

Monday, 20 Aug 2012 | 4:05 PM ET

A volatility product is the best-performing Exchange Traded Product (ETP) this year...but that doesn’t mean you should rush into it. Here's why.

It's the Credit Suisse Inverse VIX, and it's up 116 percent this year, the single best-performing ETPs this year.

It is essentially the inverse of a Barclays ETN, the VXX, which is supposed to provide access to the CBOE Volatility Index (VIX).

Both of these products are among the hottest ETPs this year, because trading volatility — both with and against it — is hot.

The XIV trades on the inverse of the Volatility index — so when volatility is low, it's up. That's been a great bet this year. But be careful with these volatility products.

Let's look at the VXX. The VIX this year is down 37 percent, the VXX is down 68 percent.

Huh? The problem with the VXX is it's structure, and because of that it's almost invariably a money-loser when held for longer periods of time. That's because the VXX owns the front month VIX futures contract. These vehicles are constantly rolling over the front month contract into the next month contract. The VIX curve is almost always in contango — contracts farther out are more expensive than those that expire earlier. That means over time you keep losing money because the ETN has to keep buying more-expensive contracts. You keep losing money even if spot volatility remains flat! Ouch!

And that, of course, means that the VXX does not track the VIX.

So what's the rationale for owning VXX? It can be a great way to make money over a short period of time.

For example, these instruments are very volatile; and on very volatile days the VXX will usually move more on a percentage basis than the VIX. If you think there is going to be a sudden spike in volatility in the next few days, the VXX may be a good way to get outsized exposure.

One way to counter this is to play the opposite of the VXX...The XIV, which is the inverse of the VXX. When volatility is dropping, the XIV is going up. Here you are essentially betting that the VIX futures will remain in contango, and you're getting paid for it.

A lot of people have been making this bet on low front-month volatility recently. That's why volume in the XIV has been heavy in the past few months.

Of course, the opposite is true for the XIV..if volatility jumps, the XIV will drop fast.

Here is a tougher question: why are VIX futures in such steep contango? Spot VIX is 14.51, September is 18.65, November 22.27, January 25.20.

One reason: many of these volatility funds own those futures! As these funds get bigger, they have to roll over a higher dollar value of those futures, so they own more and more...distortion!

A second reason is that the market are expecting a lot of potentially volatile events in the coming months...uncertainty over Europe, the U.S. presidential election, the fiscal cliff. It's possible that if these events come with relatively little upheaval, VIX futures will flatten out, though they are unlikely to reverse and go into outright backwardation.

Here's another question I get asked a lot: why can't you own the cash VIX? More accurately, why is there no instrument that exactly replicates the VIX? Because the VIX is just a formula for measuring implied volatility. It measures the near term price of options (puts and calls) on the S&P 500...to replicate that index you would need to be constantly buying and selling those near term options; the transaction costs would be huge. It's not feasible.

Another caveat: both of these vehicles are Exchange Traded Notes...they are only backed by the company's credit, not by assets that are held in a custodial bank, which is the case with an Exchange Traded Fund (ETF).

—By CNBC’s Bob Pisani

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  • A CNBC reporter since 1990, Bob Pisani covers Wall Street from the floor of the New York Stock Exchange.

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