One of the most painful experiences of my half century long trading life involved the Credit Suisse VelocityShares Daily Inverse VIX Short-Term ETNs (XIV).

I was certain that the Volatility Index (VIX) would peak for the year at the Wednesday, February 5, 8:30 AM market opening. So, I shot out a Trade Alert to place only 10% of your capital into the (XIV), a bet that the (VIX) would fall. There was only a 15-minute window before the market closed during which readers could get in. A few managed to do it.

The (XIV) had just fallen from $147 to $95.00. We got in at $97.08, and it closed the day at $100. The (VIX) closed at $37. And we had made money many times selling short volatility over the past decade on spikes just like this one. The (XIV) had been the fastest growing of 3,500 ETFs over the past five years. So far, so good.

Then an hour after the close, I received an urgent call from a client. The (XIV) was trading at $14. What's up?

My initial instinct was that a major hedge fund had either gone bankrupt or had a margin call and was suffering a forced liquidation in the aftermarket.

Overnight, the (XIV) traded as low as $6.50. I later heard that Credit Suisse itself was the major buyer of volatility in the aftermarket, in fact was the ONLY buyer, and that it was deliberately attempting to bankrupt its own fund to limit its liability. Those in management in Zurich were afraid that if the (VIX) shot up to $100 it might take the entire bank down. In short, they panicked.

The next morning they issued notice that they were closing the fund in 10 days. I was certain that the managers were guilty of insider trading and securities fraud in ordering the emergency short cover, and that it was just a matter of time before the class action suits emerged.

Three months later, the lawsuit has been filed by the Gibbs Law Group in Oakland, CA, in the Southern District of New York for unspecified damages, expenses, and legal fees, with a jury trial demanded.

The last time I was involved with one of these was with the MF Global bankruptcy in 2011, where I and most of the rest of the trading community had an account.

I was initially offered 25 cents on the dollar. I refused, expecting to eventually get paid in full. I knew that the MF assets in question were never lost, they were just caught up in a conflict between U.S. and U.S. bankruptcy law that would eventually be resolved. That is what happened, and I was paid in full three years later.

The (XIV) case is much more complicated because there was a huge real loss, about $2 billion, and it involved complex mathematically constructed derivatives. Since the managers behaved so reprehensibly, and because the evidence of their misdeeds is so overwhelming, it is unlikely that the case will ever come to trial. Instead, there will be an out-of-court settlement.

If the SEC takes action it will further strengthen the plaintiffs' hands. There is currently an investigation of Credit Suisse underway and it ultimately could get banned from doing business in the United States.

My bet is that investors will get at least half their money back, if not more. But it could take years to get it, and in a class action the lawyers get a big chunk of any awards for their efforts, usually one-third. Sometimes, class actions can last as long as 10 years.

As for my own followers, most followed my advice to put no more than 10% of their capital into the trade. As it turned out, they made back the 9% loss in less than a month, half of it through selling volatility short again. But this time I used put spreads on the iPath S&P 500 VIX Short-Term Futures ETN (VXX), a long volatility play that will never go to zero overnight.

To read the suit in its entirety, please click here.

To learn more about the suit, please click here and here.

Or you can call the Gibbs Law Group directly at 510-350-9700. I'm sure they'd love to hear from you.

Trading Volatility Can Be Hazardous to Your Wealth