The demise of the short volatility Exchange Traded Note (ETN) with ticker XIV, has led some media observers to suggest that the short volatility trade is dead. I would argue that many short-biased strategies continue to thrive, but trading volatility requires a more sophisticated approach than either long-only or short-only.
By Hamlin Lovell
The death of XIV was bound to happen sooner or later. A short-only strategy carries theoretically unlimited risk. If a strategy is 100% short of anything which rises by at least 100%, the value drops to zero. The XIV prospectus warned that the long term expected value was indeed zero! On February 6th 2018, XIV lost nearly all of its value, and Credit Suisse decided to close it (a handful of other short volatility ETFs/ETNs still exist, and most are down around 90% in the first two months of 2018).
Long-only volatility ETFs are up 40-50% in the first two months of 2018, but this is starting from a very low base. Long term, they have often lost over 99% of their value, because im-plied volatility trades at a premium to realised volatility most of the time. The negative compounding effect results in a value that asymptotically approaches zero. This also means that shorting volatility is one of the most persistent risk premiums.
Volatility risk premiums
Short-biased volatility strategies will typically sell volatility on a limited risk basis. This might involve “selling the belly and buying the wings”, in the jargon: this might be imple-mented by selling options 10% either side of the current market price, and buying them 20% or 30% either side. It could entail spread trades, that are short of volatility below one strike price, but long of it above a higher strike price. It is possible to buy call options on the VIX future, to hedge a short position.
Or it could simply involve smaller position sizes with a strict money management rule that banks profits at regular intervals to stop the position from growing too large; in contrast the ETFs reset their exposure daily and stay more or less fully invested. Selling volatility is not a strategy, like finding the next Netflix or Amazon, where investors should run their winners for years. In common with owning catastrophe bonds that saw big losses in 2017, the ques-tion is not if, but when, large losses will occur.