On Shorting VIX, Volatility Spikes, and Leveraged Vehicles

Analyzing a recent CBOE presentation on the short CBOE Volatility Index (VIX) trade

Mar 13, 2015 at 8:12 AM
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It's been a somewhat interesting week in volatility land, as we're in the midst of our bi-monthly CBOE Volatility Index (VIX) spike, brought to you by the euro plunge. Thus, I've neglected to mention this event:

"On Friday at the 31st Annual Risk Management Conference presentations on -- Selling Volatility Safely: VIX, VXX, and Other Short Volatility Option Strategies -- were delivered by David Burchmore, Portfolio Manager, Ontario Teachers' Pension Plan, and Rocky Fishman, CFA, Equity Derivatives Strategy, Deutsche Bank Securities."

Matt Moran of the CBOE gives us some bullet points from Mr. Fishman's presentation, so let's discuss a bit.

  • "Short volatility trades can capture rapid drops in volatility; the month of November 2014 had an SPX realized volatility of 4.5, the lowest monthly number since 1966."

The one commonality of short volatility trading is that it works more often than not. In other words: sell options, and there are better than even odds you will make money. But, that doesn't mean it's a positive expected value trade. That's because there's a maximum profit on the shorting side, but unlimited loss potential on the other side. You rarely do max out losses, but they do tend to dwarf wins in size. I am a believer in net shorting options or net shorting volatility as a strategy, but it requires major discipline and a willingness to eat some losses before they snowball into huge losses.

  • "Volatility spikes have become more intense -- a trend we expect to continue."

We've noticed the same thing. The frequency of these spikes has picked up. At some point, they're not really "spikes" anymore. Rather, they're longer-lasting volatility regime changes. We'll be on the lookout, though it will only be known for sure in hindsight.

  • "VIX Futures fall more often than they rise, and most VIX futures drop in price over their final weeks."

  • "VIX futures usually trend downward, even when volatility levels do not."

A thousand times yes! We options folk had a discussion of this a month or two back. It's not a certainty that futures drift towards cash, but it's a favorite to happen. By and large, futures are lousy predictors of forward VIX prices.

  • "VIX ETP space trending toward more VIX-based products with 2-times exposure, and inverse products."

  • "A key driver of high vol-of-vol is the growth in VIX-based ETPs with 2-times exposure, and inverse products."

Well, that's all a comforting thought. Volatility products are often complex and misunderstood, though anecdotally it feels like more and more people have figured them out. I don't believe the doubled products have gotten so big that the tails effectively wag the dogs yet. But I don't doubt that they have an impact on the margins. Someone trapped in a bad doubled position could clearly have an outsized effect on the volatility complex if forced to chase. The overall number of people trading these leveraged and inverse volatility vehicles just isn't that huge.

  • "VIX and VXX put options are core tools for selling implied volatility; VIX and VXX put options both target VIX futures but their economics differ."

Speaking of confusing points … if you sell VIX or iPath S&P 500 VIX Short-Term Futures ETN (VXX) puts, you're going long volatility. But you're doing it by selling volatility-of-volatility.

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


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