The Tell: How a 6,000% profit on a single trade saved a small hedge fund from disaster

Last week, while countless others were getting annihilated, Lincoln Edwards saw the millions of dollars he manages for a small Austin, Texas-based hedge fund double in the span of just 15 minutes, thanks to a wicked spike in volatility that rattled the stock market and blew up one of Wall Street’s most popular — and profitable — trades.

A 6,000% return on a single position will do that for you.

“We basically bought what amounts to insurance against a hurricane destroying our house,” Edwards said in an interview on Wednesday. “We couldn’t have predicted when this storm would hit, but if we hadn’t protected ourselves, we would have been completely knocked out.”

There were plenty of others who, indeed, were completely knocked out.

After all, the Dow Jones Industrial Average DJIA, +0.21%  had registered its biggest drop in several years, which triggered a swift surge in the “fear gauge” VIX, +3.84%  and gutted those betting heavily on the market serenity to continue.

One retail trader shared his story of losing $4 million overnight when the VelocityShares Daily Inverse VIX Short Term ETN XIV, -0.17%  lost nearly all its value. A similar fate would have befallen Edwards had he not bought puts on the ProShares Short VIX Short-Term futures ETF SVXY, +0.25% an alternative to the XIV.

“It was mostly just part of our risk management process,” he explained. “Always cap the downside.”

‘People were laughing at us, saying this could never happen, this should never happen.’

Justin Borus

Edwards, of course, wasn’t the only fortunate options-buyer to ring up profits from the chaos. Another story of a VIX-related windfall last week came out of Denver, where traders at a hedge fund turned a $200,000 bet into a $17.5-million payday.

“People were laughing at us, saying this could never happen, this should never happen,” Justin Borus, the 41-year-old founder and manager at Ibex Investors, told Bloomberg last week. “We saw people pricing this as a 1-in-5,000 event, but it was more like a one-in-five-year event.”

Also read: The trade that made $400M on the volatility spike.

As for Edwards, his epic trade was more than just a lottery ticket.

Like so many others players in the volatility space, he had capitalized on the stock market’s historic calm over the past year, with his Houndstooth Capital Management clients enjoying an impressive 104% return in 2017. While that kind of performance is fantastic for any fund, it would have been much better for Houndstooth if it wasn’t for the cost of keeping those protections in place.

“We never would have put that XIV trade on without protection,” he said, even if it meant missing out on some of the upside other volatility traders did. But nobody’s complaining about that now.

What’s next? Edwards is currently in wait-and-see mode.

“How the dust settles is unclear,” he said. “Either the short volatility crowd could get significantly thinned out or we could see people double down.”

In the meantime, Edwards has shifted his clients into cash until he figures out his next move. “No shame in being cautious in this ambiguous market,” he said.

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