How to Spot the 'Kiss of Death' in the Market
Editor's note: Investors were making a dangerous bet...
But they had no idea how much risk they were actually taking.
Fortunately, if you've been reading our work for long, your portfolio didn't "blow up" during the recent market correction.
In today's Masters Series essay, we conclude our exclusive interview with Stansberry Alpha editor Alan Gula. In today's installment, Alan discusses this dangerous trade... and explains how he's preparing his readers for a bear market...
How to Spot the 'Kiss of Death' in the Market
An interview with Alan Gula, editor, Stansberry Alpha
Sam Latter: Did you see something in the Dollar General (DG) trade that worried you?
Alan Gula: The stock had gone from being super cheap to the most expensive it had ever been. Fortunately, my analysis had proved correct, and the market finally agreed. It looked like a good time to take profits.
But I was also watching some broader market trends that had me worried...
When a strategy becomes really popular, that's usually the kiss of death. And by the end of 2017, shorting volatility had become insanely popular. I put out a warning in the November issue of Stansberry Alpha. I told subscribers about the story of Seth Golden, a former logistics manager at Target. Seth had made millions of dollars shorting volatility. He was basically betting that the CBOE Volatility Index (or "VIX") would continue to decline.
I also noted at the time that some exchange-traded products (or "ETPs") designed to short volatility had garnered significant assets. The VelocityShares Daily Inverse VIX Short-Term ETN (XIV) and the ProShares Short VIX Short-Term Futures Fund (SVXY) were the most popular.
The VIX fell below 9 last year and early this year. We knew that couldn't continue forever, but people like Seth Golden were still betting that it would fall. It was a recipe for disaster.
Lo and behold, the short volatility trade blew up earlier this month. Anyone who was short VIX futures got crushed. XIV shares fell from $125 to less than $6 in three trading days. The spike in VIX futures wiped out more than 90% of its value. The losses in XIV were so severe that it triggered a "redemption," meaning the brief spike in volatility had essentially killed the product.
The problem was that many people didn't understand the risks associated with these products or shorting volatility in general. We had gone on a record stretch of more than 400 days without a 5% correction in the S&P 500 Index. The market has rarely, if ever, been more complacent. Even a relatively minor pullback in the stock market triggered a panic.
Sam: Does that mean your returns suffered before the recent spike in volatility?
Alan: Not at all, actually. From August 2015 through December 2017, three out of every four Stansberry Alpha trades turned a profit. The average annualized gain was 32% (on margin). That's more than double the benchmark's 14% return.
In this case, the benchmark was a time-weighted S&P 500 average. It sounds complicated, but it essentially means that for each trade, we looked at how the S&P 500 performed over the same time period. Then we averaged all of those amounts to get the overall benchmark.
Because of this outstanding performance, I'm proud to say we earned an "A" in the most recent Stansberry Report Card.
Sam: But bull markets don't last forever, and this one is getting long in the tooth. So what will happen to the Alpha strategy when a bear market finally arrives?
Alan: Like most other trading services at Stansberry Research, we have defined stop losses for all of our positions. That's how we manage risk in the individual trades.
We're sellers of volatility in Stansberry Alpha, but we don't short volatility recklessly. Our subscribers comfortably weathered the volatility shock this month. And I'll continue to warn them about dangerous situations like we had last year.
Plus, I've been actively preparing for a bear market. By design, we don't have a lot of trades in the Stansberry Alpha portfolio right now. By being cautious when the markets are complacent, we can make sure to have "dry powder" ready to deploy when the timing is right... like with our recommendation last week.
Sam: In general, what kinds of companies do you target when you're looking to make an Alpha trade?
Alan: These are almost entirely large-cap stocks. And of course, they're companies that we would want to own outright. But instead of buying the underlying shares, we're getting paid to enter an options trade.
Over the past 12 months, we've booked triple-digit gains on Warren Buffett's Berkshire Hathaway (BRK-B), resource giant BHP Billiton (BHP), and credit-card firm American Express (AXP). These stocks are familiar to most investors. And we'll often recommend Alpha positions on companies that are already in the portfolio of Stansberry's Investment Advisory, our flagship newsletter.
Sam: The VIX has pulled back to around 20. Has the "window" for volatility closed already, or do investors still have a good opportunity right now?
Alan: There are still opportunities...
Of course, we can earn bigger premiums by using the Stansberry Alpha strategy when the VIX is above 20. But we've shown that even during times of incredible complacency in the market, we can still find attractive trades and generate impressive returns.
Keep in mind, we entered the Dollar General trade when the VIX was only around 16. There may not have been much fear in the broader stock market. But investors were panicking about many retailers, including Dollar General. The stock had declined nearly 30% from its peak.
Sam: I have to say, the strategy you use in Stansberry Alpha is compelling. So why do you think more investors aren't trading this way?
Alan: Most investors don't even know about this strategy. Others may be intimidated by the idea of trading options. But it's much easier than you might think. If you know how to buy a stock in your online brokerage account, you won't have any trouble placing Stansberry Alpha trades.
With each recommendation, we tell you exactly which options to buy and sell. And we describe in detail your risk and how the trade could play out under various scenarios.
Whether you're an options pro or just a beginner, Stansberry Alpha is a strategy you should consider putting to work with part of your portfolio.
Sam: Did you have anything else to add?
Alan: The main thing I want to note is that I don't think we've seen the last of volatility for the year. We're in a different environment than the doldrums of 2017. I expect some more sharp pullbacks. And when the VIX does spike, Stansberry Alpha subscribers will continue to take advantage of the fear in the market.
Sam: Thanks for sitting down with us today.
Alan: It's my pleasure, Sam.
Editor's note: As Alan explained, the recent market pullback showed just how complacent investors had been... And when the bull market finally runs out of gas, his Stansberry Alpha subscribers will be able to not only protect their portfolios, but profit...
This trading strategy is powerful. But hardly anyone knows how it works. That's why we just released a brand-new text presentation where you can read all about it... and learn how to put this strategy to work to start generating thousands of dollars per month. Learn more here.