Without wanting to sound a tiny bit smug but can anyone have been surprised that volatility measures such as the Vix shot up over the last few weeks? I’ve been expecting an uptick in volatility for months – if not years. In this blog, I’ve been commenting adnauseum about the exceptionally low levels of stock market volatility. The last time we saw measures for the Vix move into single digits was back in late 2006 and early 2007 – and we all know what happened next. So, in simple terms, anyone who was still short Volatility and the Vix was probably playing with fire. Cue the entirely unsurprising news that a number of US volatility products have now ‘blown up’. The Cboe Volatility Index soared three-fold in just three days as $3 trillion was wiped from equities amid signs the U.S. economy could be overheating. And what started in the US has also hit other developed world markets – the VFTSE went from under 10 to peak at over 23 while the VSTOXX also shot up to 35.4 from a low of 11 over last month.

This clearly caught many US investors on the hop – and Credit Suisse Group AG was forced announce that it would liquidate one investment product while more than a dozen others products were halted after their values sunk toward zero. Bloomberg reported that Credit Suisse will buy back its VelocityShares Daily Inverse VIX Short-term ETN, ticker XIV. The news website reported that the fund’s market value topped $2 billion in late January; it was down 93 percent before trading was halted.

Clearly going short the Vix was a daft trade. What was probably a much better idea was to invest in a leveraged tracker. I say these words with bated breath because I sometimes suspect that short and leveraged (S&L) trackers – with anything between 1 to 5 times daily returns – are regarded with some disdain by many investors (and probably more than a few regulators). They’re seen as day traders products, used by speculative ‘suckers’ who have no idea of what they’re using. In my experience, this is very far from the truth. Like many fairly experienced investors, I’ve used S&L products, not frequently but during key market turning points. They serve a purpose, and if used intelligently can also help hedge a portfolio.

In essence, they do what they say on the tin. They lever up daily returns on both the upside and the downside. There are some 1x and 2x daily leverage products, but I suspect the biggest market is in 3x returns, with 5x increasingly popular. The clue as to what they do is the daily leveraged bit of the description. They leverage up daily returns. The big providers are SocGen (SL), Boost (part of Wisdom Tree) and ETF Securities (recently taken over by Wisdom tree).

Which brings us to the golden rule. Don’t invest in these for weeks, months and years. These are NOT buy and hold products. My suspicion is that most investors probably only hold on to them for a few days at most or maybe a week or two. Over time the daily volatility can interfere with returns which means you have to be very specific about both what you want out of the products and your own risk levels.

The next golden rule is to only invest in these products if you are relatively certain of a key trend or a specific outcome. I dally a bit in technical analysis (badly) and what I have managed to learn is that the trend can be your friend. It’s simple logic – investors crowd into trades, and then over react on both the way up and the way down. The idea is to capture this short term, news specific trend. By definition, this also suggests that the holding period for an S&L product should be brief.

Lastly, investors also need to focus on the liquidity of the instrument – the main competitor to S&L products are spread betting platforms where liquidity is usually deep and wide. Make sure you have an issuer that can provide proper liquidity on exchange for your S&L product.

OK, so with the usual disclaimers out of the way, how did the S&L products perform during the recent stockmarket ‘bump’? In the table below I’ve highlighted one obvious trend – the falling FTSE 100 index. I’ve tracked the performance of three ‘short’ or ‘bearish’ S&L trackers which each offers 3x daily leverage. I’ve broken out returns for the 1 month through to Feb 26^th as well as returns for the last year. Surprise, surprise – over the month the S&L trackers all produced big gains over the index while the benchmark fell markedly. It also shouldn’t come as a surprise to discover that over the year returns have been terrible. As a side note over 3 years, those returns have been even more horrible – the FTSE is up just under 15% but the S&L trackers are down 59%. To repeat – these are NOT long term buy and hold instruments.

The next two columns look at returns from the recent high on January 12^th (the FTSE hit 7784) through to the recent low on February 9^th (the FTSE hit 7076). Over those approximately three weeks the index lost 8.8% but all three trackers increased by 30%. During this period markets did move around substantially, but overall the trackers all delivered on their promise. In addition, I also looked at a much smaller period of time – from January 29^th through to February 6^th – the FTSE fell from 7673 to 7137, a fall of 6.9% in just over a week. All three trackers increased by 22% – exactly as advertised.

I’d also observe that all three produced almost exactly the same return, give or take a few basis points. Again, this shouldn’t come as a great surprise. My guess is that the small differences might be to do with the cost of running the products, which varies between provider. But given that most investors aren’t going to be using these products for just a few days, the annual cost probably doesn’t matter hugely in the great scheme of things. What matters I guess is liquidity and ease of trading – and whether your dealing platform lets you access the product.  But the moral of the story is clear – S&L products were probably a much better to play the recent bump than insanely complicated vol products.