Avoid the Crowded Rail

In early March 2004, The Lady D, a 36-foot two-ton pontoon used as a water taxi, flipped over in Baltimore Harbor, spilling 23 tourists into the icy Patapsco River, killing five and sending the rest to the hospital.

The boat picked up passengers on a clear, sunny, 40-degree day. The water was smooth in the protected harbor just east of the downtown skyscrapers.

The Lady D was built like a glass brick on two aluminum pontoons. It had sliding doors to an outdoor deck and big sliding glass windows for optimal viewing. In other words, The Lady D had the aerodynamics of a boxcar and the hydrodynamics of an oil barrel. A single outboard hung off the stern.

Storm Cell

Baltimore Harbor is known for its microbursts, where storm cells blowing up the East Coast rip down the hill and are funneled through the city's canyons by North/South streets like Charles and Calvert. These gale force winds are blown out the other end over the harbor.

That's just what happened in this case. With little warning, the gust estimated at 50 miles per hour caught the port, stern corner of The Lady D, lifting it and pushing the starboard bow below the water.

The skipper threw the helm over in a counter-steer just as the 23 passengers raced to the high side.

He Went Too Far...

The next gust hit the boat on the starboard side, with all the weight of the tourists now on the port side. The boat flipped in full view of the Naval Reserve station at Fort McHenry.

These Navy sailors were at the scene within 20 minutes, heroically pulling the survivors to safety and providing other first aid.

This tragedy could have been avoided if the passengers stayed in their seats and distributed the weight equally and/or if the helmsman pointed the boat into the wind. Alas, it was hit broadside with 2,000 pounds of humans on the leeward rail.

Shorting the Volume of Volume

I remember hearing about The Lady D tragedy many years ago and thinking that it's just like what happens in the market. It's part of what it means to be a contrarian.

It could be that this particular water taxi handled microbursts 100 times before. But this one time things went wrong.

Let's look at what happened last week in the stock market. Like the bright sunny day, for years, the volatility index fell.

What is the volatility index? To put it simply, it tries to measure movement in the S&P 500 using one-month-out futures contracts. There are 25 exchange-traded products (ETPs) that use the VIX as the basis of their trading.

The VIX has been down due to the fad of passive investing coupled with machine trading and the wholesale firing of active managers. To put it simply, ETPs have replaced managed funds. ETPs don't trade. Volume goes down. Volatility goes down.

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So, the "short volatility" trade was the go-to 100% money-winning trade for the last two or three years. Volatility goes down, you make money. Easy.

In order to satisfy this demand, special ETPs such as XIV and SVXY that use futures to short volatility sprang up to meet the need.

These ETPs aimed to provide daily inverse leverage on a VIX futures basket. So what happens when the VIX jumps 100% in a day?

You get a chart like this:

Last week when the bottom fell out of the Dow, ETPs that short volatility lost 96% of their value.

Now, I get that this is more complicated than baccarat... and it's no different in terms of gambling.

But the upshot is that just like The Lady D, the trade was overcrowded to one side. Due to their great record in 2017, XIV and SVXY had grown significantly in size, pushing the potential rebalance to unprecedented levels.

Over the weekend from February 2 to February 5, the VIX increased from 15.20 to 29.81, a 96% increase in a single day. The vast majority of this happened in a 15-minute period at 4 p.m. on Monday. By 4:15 p.m., the VIX short products had to buy back almost all of the 200,000 VIX futures they were short.

They couldn't do it. XIV and SVXY will be settled out for pennies on the dollar and will no longer exist.

But if you'd have played the contrarian and taken the other side of the trade, you'd have made your fortune. I have heard at least one investor who turned $200K into $17.5 million on long-term SVXY puts.

All the best,

Christian DeHaemer

Since1995, Christian DeHaemer has specialized in frontier marketopportunities. He has traveled extensively and invested in places asvaried as Cuba, Mongolia, and Kenya. Chris believes the best way tomake money is to get there first with the most. Christian is the founderof Crisis & Opportunity and Managing Director of Wealth Daily. He is also a contributor for Energy & Capital. For more on Christian, see his editor's page.