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Should You Be Using Volatility Products? A Q&A with Steven Sears

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MINYANVILLE ORIGINAL Our guest this week is the one and only Steven Sears, the Striking Price columnist for Barron's and author of The Indomitable Investor: Why a Few Succeed in the Stock Market When Everyone Else Fails.

Adam Warner for Minyanville: I really related to your chapter titled "Greed." Not that I'm greedy (I don't think, at least), but rather about our difficulty taking losses. My dad always preached to "sell half." In other words, if a position is just eating away at you mentally and you're missing other opportunities, cut it in half. Heads you bottomed it and you still benefit if it turns around. Tails, it keeps going lower, in which case, at least you mitigated the loss. Does it make much sense as a general concept, at least in terms of getting yourself in the right frame of mind?

Steven Sears: I am always amazed at how confident people are about investing. It is often the one area in their life that they approach expecting to win. They always have all kinds of plans for what they will do with all the money they will make. They never think what would happen if their dearly beloved stock declines. And when the stock does decline, most people tend to get stubborn because they cannot bear to admit they made a mistake. After they have lost a real chunk of money, they panic and sell. Even then, they are more likely to blame Wall Street and say the game is rigged – which is true to a degree – than to confront their own failings.

I like what your dad told you. He’s clearly a wise man. My dad once told me that there was always time to make money and to remember that when handling investments. I found my dad’s advice liberating. Of course, there’s more than one way to skin the proverbial cat, and in my book, The Indomitable Investor, I wanted to give people a multidimensional way to think about buying – and selling – stocks.  In our world, no one really talks about how much they are going to make but about risk levels so your investments or trades are not torpedoed. If they learn anything from my book, I hope it is the importance of developing a sell discipline. I’ve laid out a few easy-to-follow examples ranging from stop-loss orders to rebalancing. None of it is terribly complicated. But it is difficult to master the discipline.  

I don’t know if it’s a product of age or experience or both, but I’m mostly concerned with what I don’t know and trying to find out what’s wrong with what I think I know. For me, the sell discipline is part of that construct. The minute I realize that I made a mistake, or something happened that changes the investment thesis, I’m gone. I want to live to play another day.

MV: Couldn’t agree more. When I was a floor trader, I had the trading philosophy that the best way to make money was to not lose money. Of course we had all sorts of built-in edges back then; it's not quite so simple now. But the same disciplines still are valid.

Is there any way to protect VIX ETF product traders from themselves? Maybe a special certification to trade them, similar to the way options themselves are modestly walled off until you *prove* you understand them? I believe in general, investors are better informed in this regard, but then you get the next TVIX accident or VXX drift and the conspiracy theories about MM's "rigging" these products come out again.

SS: I don’t really understand why it is that people who have trouble consistently earning high returns on vanilla stocks or ETFs think they can master complicated volatility products. I suppose that the fact that so many like to trade complicated VIX products is testament to the effectiveness of Wall Street’s marketing machine. Take TVIX. All most people know about TVIX prior to trading is that is designed to move a lot more than VIX. That’s all it takes to get people to buy really complicated stuff. I think that’s the genius of the Street’s marketing machine. The machine gets investors to focus on the end result without thinking much more deeply about what it takes to get there. Individual investors are conditioned by Wall Street to focus on profit, not process, reward not risk. It’s the exact opposite of how professional, seasoned investors approach the market.

I know guys who are the most sophisticated derivatives traders on the planet who will not touch anything that they think is a derivative of a derivative. A derivative is complicated enough to price and understand. A derivative of a derivative has too many moving parts for most people to comprehend. Yet, people who do not know the difference between implied volatility and historic volatility rush to buy these complicated products that marketers make easy to understand with slick marketing slogans.

Oscar Wilde once said a burnt child loves the fire. VIX products are great examples of that. Many people want to rub up against the more rarefied areas of the market, and these structured products let them do it without spending time understanding what they are trading or how that part of the market functions.

I bet if we did a random survey of VIX traders that most would have no idea VIX options or even VIX ETF products are priced off VIX futures. I would love to see VIX products carry a warning label in simple language that anyone could understand. I tried to read the TVIX regulatory filings, and I couldn’t understand how it really traded or where the prices came from.

In Vegas, you can check out the odds of success on various games. I would love to see that assigned to various structured products – especially volatility products. How many people would trade some complication if it said in bold print that you have an 8 in 10 chance of losing money?

MV: In hindsight, the real genius was just putting VIX in the “TVIX” name; it implies all sorts of correlation that’s just not there.

By the way, whatever happened to black swans? They were everywhere in our lexicon; now it's all "risk on/risk off." I kind of miss the black swanning of everything. Like Cyprus needing money. I'd guess 99% of investors couldn't find it on a map, so it's almost a black swan by definition.

SS: I think the lesson of the credit crisis is that correlation trumps diversification. MPT, or Modern Portfolio Theory, which is a key basis of modern finance, is predicated on the simple fact that a diversified portfolio minimizes risk. The Credit Crisis of 2007 body slammed MPT. Now, many institutional investors are geared to minimize losses by hedging. “Cheap and deep” is the new mantra as investors buy cheap, deep out-of-the-money puts or use put-spread collars to hedge portfolios. The constant hedge lets investors focus on the tactical risk on/ risk off trading. Once the market ceases to be so choppy, and everyone gets a little drunk off a sustained rally, and the economic is healthier, and jobless rates really drop, the black swan will come back with the vengeance of a honey badger. Actually, maybe it’s the honey badger we need to fear.

MV: Yeah, it's probably toughest of all worlds;, the markets chopping and those cheap-and-deeps aren’t helping much in this.

I've misspelled your first name as "Stephen" pretty much since I've known you. Actually, you very politely reminded me of it once, like, "I prefer Steven, but whatever you want to use is good." Anyway, I did it again when I hit you up on Amazon. Turns out there is an author that spells your name wrong that has all sorts of Civil War books. I have a namesake that writes books on WWII-era Germany. Are we in the wrong field? This all sounds like it beats options and finance.

SS: You’ve misspelled my first name for so long that even I’m confused now! True story. I’ve encountered my doppelganger a few times before in real life. I like to shop at the Abraham Lincoln Book Store in Chicago and so does the guy who spells Steven the fancy way. They always ask which Sears I am. I don’t think we’re in the wrong field. I’m a bit biased, but I think we’re doing OK. We have a front-row seat to the greatest show in history and we’re in the arena. What’s better than a life of writing and action?

MV: OK, I gotta ask, what's Alan Abelson like off-stage? Is he some wild, cockeyed optimist? I have this vision he's hanging out in the office with his cigars laughing at all of us?

SS: Don’t tell anyone, but I’ve never met Alan. I’ve seen him once at our Art of Successful Investing Conference and that’s it in all my years at Barron’s. My view of him is not much different than yours. I see him like a cross between Mark Twain and a wizened floor broker. We’re lucky to have him.

MV: That confirms my other theory then, that he’s actually a composite character.  Many thanks to Steven for participating this week!

Twitter: @agwarner

POSITION:  No positions in stocks mentioned.