Short Vol, Beanie Babies And Crypto Currencies: Where Money Goes To Die

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Short Vol, Beanie Babies And Crypto Currencies: Where Money Goes To Die
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It is often a wise thing to look around and see where people are doing that is nuts.  Often it is obvious in advance.  In the past, the two most obvious were the dot-com bubble and the housing bubble.  Today, we have two unrelated pockets of nuttiness, neither of which is as big: cryptocurrencies and shorting volatility.

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I have often said that that lure of free money brings out the worst economic behavior in people.  That goes double when people see others who they deem less competent than themselves seemingly making lots of money when they are not.

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I’ve written about Bitcoin before.  It has three main weaknesses:

  • No intrinsic value — can’t be used of themselves to produce something else.
  • Cannot be used to settle all debts, public and private
  • Less secure than insured bank deposits

In an economic world where everything is relative in a sense — things only have value because people want them, some might argue that cryptocurrencies have value because some people want them.  That’s fine, sort of.  But how many people, and are there alternative uses that transcend exchange?  Even in exchange, how legally broad is the economic net for required exchangability?  Only legal tender satisfies that.

That there may be some scarcity value for some cryptocurrencies puts them in the same class as some Beanie Babies.  At least the Beanie Babies have the alternative use for kids to play with, even though it ruins the collectibility.  (We actually had a moderately rare one, but didn’t know it and our kids happily played with it.  Isn’t that wonderful?  How much is the happiness of a kid worth?)

I commented in my Bitcoin article that it was like Penny Stocks, and that’s even more true with all of the promoters touting their own little cryptocurrencies.  The promoters get the benefit, and those who speculate early in the boom, and the losers are those fools who get there late.

There’s a decent public policy argument for delisting penny stocks with no real business behind them; things that are worth nothing are the easiest things to spin tales about.  Remember that absurd is like infinity.  If any positive value is absurd, so is the value at two, five, ten, and one hundred times that level.

The same idea applies to cryptocurrencies; a good argument could be made that they all should be made illegal.  (Give China a little credit for starting to limit them.)  It’s almost like we let any promoter set up his own Madoff-like scheme, and sell them to speculators.  Remember, Madoff never raked off that much… but it was a negative-sum game.  Those that exited early did well at the expense of those that bought in later.

Ultimately, most of the cryptocurrencies will go out at zero.  Don’t say I didn’t warn you.

Shorting Volatility

This one is not as bad, at least if you don’t apply leverage.  Many people don’t get volatility, both applied and actual.  It spikes during panics, and reverts to a low level when things are calm.  It seems to mean-revert, but the mean is unknown, and varies considerably across different time periods.

It is like the credit cycle in many ways.  There are two ways to get killed playing credit.  One is to speculate that defaults are going to happen and overdo going short credit during the bull phase.  The other is to be a foolish yield-seeker going into the bear phase.

So it is for people waiting for volatility to spike — they die the death of one thousand cuts.  Then there are those that are short volatility because it pays off when volatility is low.  When the spike happens, many will skinned; most won’t recover what they put in.

It is tough to time the market, whether it is equity, equity volatility, or credit.  Doesn’t matter much if you are a professional or amateur.  That said, it is far better to play with simpler and cleaner investments, and adjust your risk posture between 0-100% equities, rather than cross-hedge with equity volatility products.

Again, this is one where people are very used to selling every spike in volatility.  It has been a winning strategy so far.  Remember that when enough people do that, the system changes, and it means in a real crisis, volatility will go higher than ever before, and stay higher longer.  The markets abhor free riders, and disasters tend to occur in such a way that the most dumb money gets gored.

Again, when the big volatility spike hits, remember, I warned you.  Also, for those playing long on volatility and buying protection on credit default — this has been a long credit cycle, and may go longer.  Do you have enough wherewithal to survive a longer bull phase?

To all, I wish you well in investing.  Just remember that new asset classes that have never been through a “failure cycle” tend to produce the greatest amounts of panic when they finally fail.  And, all asset classes eventually go through failure.

Article by David J. Merkel, CFA, FSA - The Aleph Blog

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David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.
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