Read This Before You Short VXX and XIV

So we know that iPath S&P 500 VIX Short-Term Futures ETN (VXX) essentially will always decline over time. And we know that a VelocityShares Daily Inverse VIX Short-Term ETN (XIV) long will underperform a VXX short over time. It begs a good question:

It's certainly tempting. I do know of a neighbor that runs a fund dedicated to pairing exchange-traded products like these and other inverse pairs in order to short them all. But it's not as simple as meets the eye.

First, let me note something I left out the other day: I didn't factor in short borrowing costs in any of my numbers. That's partly because it's mostly small or nonexistent in VXX, and partly because it's not consistent over time.

It could also work both ways. VXX can get a large float, interest rates could rise (really, they can), and you could actually earn money shorting and lending. And conversely, the long side (XIV) could cost money to hold. Most of that is close to true now, but it could all happen.

That's a long-winded way of saying there's no consideration of borrowing costs now, but yes, that could lower the relative returns of a VXX short. And it would reduce returns of shorting both sides, as you will likely pay borrowing costs on XIV.

Second -- and more importantly -- shorting both sides of any ETF or ETN pair gets you de facto short gamma. Suppose you're short $100,000 of each, and on day one, VXX lifts 10%. You're now short $110,000 VXX and short $90,000 XIV, meaning you're now net short $20,000 VXX. You can rebalance, of course … but then you lose the advantage you sought to create by shorting both. It makes more sense in the context of the fund to leave the position on. Remember, the goal is to essentially capture the mutual attrition.

And that's fine if VXX drifts back. But what if the move keeps on going? You will effectively keep getting shorter and shorter VXX. Eventually you'll have to cover, probably near when the move stops.

Does this dynamic all sound familiar? That's because it's the same experience as if you shorted gamma in VXX options (or something similar). The options will decay over time, and if nothing very unusual happens in VXX, you'll win. But if VXX makes a big move, you'll have to scramble to cover.

I do like the idea of shorting both VXX and XIV, paying the borrowing costs, and waiting it out. But it's potentially a much trickier combo than meets the eye.

Disclaimer: Mr. Warner's opinions expressed above do not necessarily represent the views of Schaeffer's Investment Research.