Broker Check

Your Team at LPA Strategic Capital

(732) 462-1180

Lessons from the Short Volatility Trade

| March 22, 2018

Last August, I wrote about a few financial strategies that posed risks to the financial system. Among them was the ‘short volatility trade’. I concluded that: “In the event of a more prolonged and pronounced down move in the stock market, the VIX may increase dramatically, and the secondary effects of the liquidation of the short VIX trade could spill over to the market in general.” This appears to have happened a few weeks ago. As the stock market corrected in early February, the VIX shot up and investment strategies that were short volatility ended up sustaining heavy losses. These losses lead to the liquidation of other assets, which had the effect of intensifying the market decline. Market observers can debate the role that the short volatility trade played in the market correction, but an equally important (and more obvious) point is that complex and somewhat exotic approaches – like shorting volatility – entail additional risks that investors need to understand.

From an objective perspective, shorting equity market volatility has some theoretical appeal. In the VIX marketplace, as a contract month rolls forward to maturity, the price generally decreases. This means that investors that are short the VIX gain the ‘carry’ as the contract gets cheaper with time. Additionally, there is substantial evidence that implied volatility is overpriced because natural hedgers are willing to overpay slightly for the cost of insuring their portfolios. For this reason, there is a persistent risk premia to be gained by selling volatility.

These rationales may be responsible for helping investors abandon any initial unease about employing such a risky strategy. There is, however, more to the story….

Selling volatility is like selling financial insurance. Thought of in this way, the question becomes: Who should be selling insurance? The obvious answer is… insurance companies. The reason insurance companies are in a good position to sell insurance without bearing extraordinary risks is that they are selling insurance to many people (and thereby collecting lots of premiums) and, as corporate entities, they have long time horizons. If an insurance company needs to pay a claim due to a house fire, the company can absorb the loss by virtue of the premiums paid by other homeowners. If there is a rash of house fires, the insurance company may need to dip into reserves, but it can replenish those reserves in future years. Most individual investors do not have the capability to sell financial insurance across the breadth of financial markets. So if the stock market declines quickly and equity volatility explodes, there are few (if any) other premiums that will mitigate the losses. Additionally, an individual investor probably isn’t indifferent to when these losses occur. An insurance company that incurs losses will dip into reserves and just reports poor earnings for that year; an individual investor may have time-specific goals – like retirement – that will be put on hold if the investor sustains losses at the wrong time. In the financial world, large institutional investors are the ‘insurance companies’. In most cases, individual investors should leave the ‘insurance selling’ to them.

Additionally, almost all strategies that enable retail investors to short volatility use daily index rebalancing. This means that a volatility index is shorted on a daily basis, and then the index is rebalanced at the end of each day. When an index is tracked over a longer time period, there is not an issue, but when it resets daily, the index can often sustain losses due to the effects of short-term volatility in the index. For example, if an index rises by 10% one day but falls by 10% the next, most investors would expect that the index (and any security tracking that index) would be back to zero. However, if an index is reset daily, then it would rise from 100 to 110 the first day, then drop to 99 the next day (since it would lose 10% of 110). This 1% loss (from 100 to 99) is attributable to what is termed ‘volatility drag’. It is in this way that daily rebalancing creates an additional hazard for volatility traders. Investors in such strategies need to be aware of this otherwise hidden risk.

The unwinding of the short volatility trade resulted in substantial losses for some, and exacerbated the market correction in early February. For investors, this should be a cautionary tale. The proliferation of complex strategies and products provide investors with choices, but unconventional approaches pose additional (and sometimes unique) risks and considerations. This doesn’t mean that all new investment products or strategies are bad; it does mean that more extensive due diligence is necessary to make sure that all the risks are well understood.