Volatility Trading - Short Side - Bad Idea?

In another thread the topic of shorting volatility came up. To keep from taking the other thread further off topic, I thought I’d trying and get the conversation started here.

From what I’ve seen, shorting volatility, whether shorting volatility ETNs, buying bear ETNs, or with selling options seems like a suckers game. Sure, in times of low volatility you can, in theory, make a profit, but you’re betting on something you have little to no insight into.

If the market crashes then volatility will spike hard, meaning that your short side is open to significant (and in some cases, open) exposure.

As a single component in an overall hedged strategy, I can see where it might be handy, but as an investment philosophy it seems like an insane idea.

I’m entirely open to the idea that I might be wrong.

So what are your experiences?
Tell me where I got it wrong so that I can learn!

If you have an actual strategy of how and when you go short volatility AND you have a sound risk management then there is absolutely no problem.

Just as an example, my short vol strategy didn´t lose a cent during the crash in February which was doomsday for any superficially designed vol strategy. Until recently I traded the strategy 100% TOS but since I´m from the EU I can´t trade those US ETF/ETN anymore…

We all know there are other strategies around that go for way higher returns. However, they take higher risks of course so it´s a matter of taste. But you really shouldn´t throw all vol strategies into one basket.

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Personally, I rely heavily on the volatility risk premium to guide whether I should be long or short volatility. There’s umpteen ways of estimating the VRP, but all of them are basically the difference between the implied volatility of the S&P500 (what we expect volatility to be in the near future) and the realized volatility (what’s actually happening). Most of the time VRP is positive, which is to say that those purchasing a long volatility position are paying a premium for that hedge because the current realized volatility is lower than that. Another way of saying that is that when the VRP is positive and stays positive, short vol positions are collecting a premium from long vol positions.

The VRP is not the same as contango/backwardation of the VIX futures, but they are correlated. The VRP tends to have a significantly better predictive power than the level of contango. You can read more about all this in Tony Cooper’s very nifty treatise from way back in 2013, “Easy Volatility Investing” (link to free download: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2255327), and it should still be considered required reading for anybody going either short or long vol funds.

It’s not a panacea. The VRP seems less effective in choppy sideways markets (like the past 6 months), versus clear market conditions upward and downward. And quick events (like Brexit) can really cause problems with missing both the market tumble and the recovery (due mainly to the lag in estimating current realized volatility). But overall, it’s pretty damn useful and kept me on the right side of the February volatility fiasco.


The easiest way to see the benefits of shorting volatility is to look at a long-term chart of VXX or TVIX. VXX has gone from about 64,000 split-adjusted to about 30 in 9 years years while TVIX has gone from about 280,000,000 split-adjusted to about 35 in 8 years. Go back to 2006 (to include a good bear market) with simulated prices based on real VIX futures values, and the results are not quite as dramatically one-sided, but still show a steep downward long-term trend.

These volatility products go down for one of two reasons – either because the VIX drops, or because the VIX futures prices converge with the spot VIX as the approach expiration. Over the last 9 years that the VXX has been around, the spot VIX has come down form averaging about 25 to averaging about 15 – so that does explain a small part of the drop in VXX prices; the rest is due to the “contango” in the futures curve. About 80% of the time, the futures prices are higher than the spot price, so over the course of a month, if the spot price stays constant, the futures prices will drop in price as they need to equal the spot by the expiration date. Because the volatility products hold (or track) the VIX futures, they will lose value when in contango even if the spot VIX doesn’t move. During the 20% of the time the VIX figures are in “backwardation” (lower than the spot price), the opposite happens – the volatility products will gain in price if the spot VIX stays constant.

Since the beginning of 2006 (using simulated prices), when in contango, the VXX lost about .30% a day and when in backwardation gained about .45% a day. Those are pretty big numbers when compounded over longer timeframes. So with a very simple strategy of being short volatility when the day started in contango and long volatility when the day started in backwardation, one would have averaged over 50% a year including transaction costs. If one would have adopted a more sophisticated strategy that uses multiple proven indicators, but follows the same basic premise, one would have averaged considerably over 50% per year.

That sounds great, and would have worked well historically, but doesn’t address a true “black swan” event, that could come out of nowhere and cause the VIX to spike dramatically. As we saw in February, the VIX can easily double in a day based on a relatively insignificant event. What if something really big happens? Instead of an empty missile flying near Japan, what if the next one is armed with a nuke and actually hits Japan? If it happened overnight, would the VIX open the next day up 3, 4, 5, 10 times higher??? Who knows – but as bad as that would be, we shouldn’t be in a position where that would wipe out our portfolio. So, protection is needed. Many on C2 use stops as protection, which are “free”, and would be effective in most situations, but would probably not be much use in any event that happened overnight or was big enough to cause a major price gap or caused the markets to halt trading. So, for effective protection against all these scenarios, options can be used. There is a cost, but it’s much like buying home-owners’ insurance…it’s not much fun paying the premiums, but I sleep much better at night knowing if something bad does happen, at least I’m protected financially.

So, to sum up my position – trading volatility smartly can lead to some amazing returns, but all could be lost unless one uses protection – so look for a smart volatility strategy that protects with options, and enjoy the returns while sleeping well at night. :blush: