E So They Say Shorting Volatility Is Like Playing With Dynamite...

I leave the country for one week, one week and return to discover that volatility has remained relatively low. But that’s not all I’ve returned to as the calls for an end to the short volatility trade and imminent disaster for such positioning have run rampant in my absence. As many already know, understand and accept, I’ve been shorting volatility now for a smidge over 5 years and doing so with astounding rates of return on invested capital (ROIC). As it were it will remain until further notice, Golden Capital Portfolio will maintain a short volatility strategy and as the fund has produced a 94.1% ROIC year-to-date. So let’s do it to it as they say and review these calls to an “end of the short volatility” trade.  I think you’re going to like or dislike this very much, depending on what you’ve already read in my stead. I’m a poet and didn’t…nahhhhhhh!

First “up to bat”, again, as they say, is an article written by Eric Parnell and titled How To Protect Against A Rise In VolatilityMr. Parnell asks a relatively simple question at the onset of his narrative while characterizing the short volatility trade as a “keg of dynamite, preparing to blow”.

What does the average investor need to do, if anything, to protect against the inevitable rise in volatility, and thus the unwinding of this short volatility trade, at some unknown point in the future?

The short volatility trade (Nasdaq:XIV) is like a keg of dynamite sitting at the heart of financial markets. Once it explodes, it is likely to come with meaningful collateral damage that could quickly spread across asset classes.

It’s a great question! But with a rather faulty premise that denies the reader/investor/trader the opportunity to best understand that most short volatility participants utilize designed instruments to participate. The question is also proposed with a predetermined outcome: The unwinding of this short volatility trade.  Regardless of the direction in volatility since the genesis of short volatility instruments, the short participation rate has only, only increased.  With that factual piece of information in hand, the outcome is not only predetermined by Mr. Parnell, but it’s absolutely incorrect with regards to history.  And “a keg of dynamite sitting at the heart of financial markets”? Well Mr. Parnell, if fear-mongering was the goal within your narrative…

Mr. Parnell’s article is well-written and well intended, but so far as content, it fails to give the full scope of why the short volatility trade has worked so very well.  The nature of volatility is the enemy of a long volatility strategy or any hedging strategy one can put forth. Everything an investor/trader needs to know is centered on the study and understanding of volatility.  At the heart of volatility is the acceptance of desensitization from introduced stimuli.  The more exposure to like stimuli, the greater the desensitization and hence the reduced volatility.  In other words, what once produced outsized levels of fear and volatility, upon previous exposure to such stimuli, will not have the ability to produce like levels of fear and volatility when exposed to the same stimuli in the future. This is desensitization and something you likely won’t see articulated by others in the media.  Why? Well because it takes effort and a dedication for considering a deeper understanding as to why something works the way it does. Mr. Parnell’s article doesn’t offer any understanding of volatility itself, even when offering several charts of when volatility spiked and subsequently falls. Through all of these magnificent volatility spike examples articulated by Mr. Parnell, the short volatility trade still grew larger, not once “blowing up” or “unwinding” in perpetuity.  The short trade only grew larger.  Look at the following example offered by Mr. Parnell as follows:

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Disclosure: I am short UVXY since 2012. I am short VXX.

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Comments

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Japela Welman 5 months ago Member's comment

Nice article...would be interested to know if you have given consideration to a point where fear reaches a point of no longer desensitizing but to horror (supernormal event) as described in pages 9 of "Volatility and the allegory of the prisoner's dilemma", written by a volatility trader from Artemis Capital - http://www.artemiscm.com/welcome#home

Seth Golden 5 months ago Author's comment

Thank you for the comment and the introduction to the title. Kindly let me digest the content and offer a response later in the week. Thank you for reading and considering my article Japela!