Is Shorting Volatility A Free Lunch?
Thinking about shorting volatility? You’re not alone.
Short interest in the long volatility ETN (VXX) has exploded higher in recent months.
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Source: RBC, Zerohedge
Why does everyone want to short vol?
1) Shorting volatility (ex: shorting the long volatility ETN VXX) has been enormously profitable since 2009…
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2) This week the Volatility Index (VIX) hit its lowest level since December 2006: 9.56.
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3) On a closing basis, only a few days in late December 1993 have seen lower levels…
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4) Over the past 13 trading days, the S&P 500 has traded in a range of 1.01% (high to low as a %), the lowest 13-day trading range in history.
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5) The Short Volatility ETN (XIV) is up 735% since its inception in November 2010 versus a gain of 130% for the S&P 500 (SPY).
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So is shorting volatility a free lunch?
While the many newcomers to the trade are likely believe so, anyone who’s been involved in markets longer than the past few months knows it is anything but.
Shorting volatility is somewhat equivalent to a highly leveraged bet on the S&P 500. When the S&P 500 goes up, volatility tends to go down, and shorting volatility tends to make money. When the VIX is in contango (2nd month futures are higher than front month futures), as is often the case, shorting volatility via ETNs like VXX provides an additional return via the roll yield (see my post here for more detail on that).
As we saw in the charts above, we’ve been in one of the lowest volatility periods in history, and VIX futures have been in a state of contango for much of this time. This has led to an almost vertical run-up in the short volatility play (XIV), particularly since the market lows after Brexit.
But a free lunch it is not. With annualized volatility of 64% since inception (vs. 15% for the S&P 500), you are very much paying the price for any higher return with much higher volatility. And even in the low volatility environment since 2010 when XIV launched, it experienced a 74% drawdown in 2011 and a 68% drawdown from 2015-16. Should a more extended bear market should ensue (the 2011 bear was shallow and short-lived), a 90+% drawdown would not be unexpected.
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Is a sharp decline for the short vol bet on its way? You can count on it; it’s not a question of if but when. With the VIX hanging around 10, a volatility spike is inevitable. And given the extreme low levels today, even a move back to the high teens in the VIX (the historical average) will feel like a crash. When that move occurs, those lining up in recent weeks to grab the supposed free lunch will learn the hard way that there is no such thing in markets. A price will be paid – if not today then in the future – but it will be paid.
Disclaimer: At Pension Partners, we use Bonds as our defensive position in our absolute return strategies for all of the above reasons. Bonds have provided a more ...
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