As equities surge to all-time highs and bullish sentiment on the S&P 500 remains. A growing number of speculators are betting that volatility will vanish, causing the short VIX trade to grow in popularity throughout 2019.
So, what exactly is the VIX and what is the premise behind the short trade? The Chicago Board Options Exchange (CBOE) Volatility Index, or VIX for short, is an index that tracks the volatility of the U.S. equity market. Essentially, the index is created by utilizing S&P 500 Index options to capture the expected market volatility for the next 30 days. The VIX normally falls in rising markets and rises during selloffs, thus, its commonly referred to as a “fear gauge.”
While the S&P 500 continues its longest bull run in history and the Federal Reserve remains dovish, market swings have remained relatively low. This favourable macroeconomic environment has made the short VIX trade extremely attractive – causing net short VIX positions to reach all-time highs in early 2019.
Before explaining the trade, we need to make it clear that KeyStone Financial does not advocate anyone taking a short position in the volatility index, as the trade carries an extremely high degree of risk. We are investors not speculators and believe in the preservation of our client’s capital.
However, traders who want to gain exposure to the short volatility trade have the option to:
- Take short positions in VIX futures or option contracts.
- Take short positions in VIX-linked products such as exchange traded notes (ETN’s).
- Take long positions in inverse volatility exchange traded notes.
There are two underlying motivations behind the short VIX trade.
The first motivation for the short VIX trade is that the volatility index is mean reverting by definition. An investor may enter into a short position while volatility is high in hope that volatility will subside and revert back to its mean at lower levels. As an example of this trade in action, following the December 2018 pull-back in the S&P 500, the volatility index spiked. Correspondingly, traders who then entered into a short volatility position experienced the underlying volatility index fall by 65.8% from December 24th, 2018 to April 23, 2019.
An alternative motivation for entering into a short volatility trade is for traders who believe volatility will remain low and are gaining exposure to the index by shorting futures contracts. If the futures term structure is steep and in “contango” (shown in the graph below), a speculator may be able to profit off of a relatively stagnant market. Contango occurs in the VIX futures market when expectations of future volatility are higher than current levels. That is, the settlement price for longer maturity futures contracts is higher than what the settlement price of a contract is today. Referring to the futures term structure graph below, the blue dots are various futures contracts with a specific settlement price (Y-axis) and maturity date (X-axis). If we were to watch a time-lapse of the graph below, overtime, the settlement prices in blue would slowly converge to the green spot price. As long as volatility remains low – the futures contract will decline in value over time as it converges to the spot price, allowing a short futures trader to realize what is called a roll-yield.
Macro Risk Advisors have recently advocated that when the futures term structure is steep and volatility expectations are higher than actual swings. Speculators can generate stronger risk-adjusted returns by shorting the VIX to produce a roll-yield, than going long the S&P 500 index. However, it should be noted that Macro Risk Advisors’ research is based upon a theoretical model that excludes borrowing costs.
This is not to say that the trade does not carry a high degree of risk, as in February of 2018, after a large market sell-off and a one-day surge in the VIX. Estimated losses for short VIX speculators were estimated at $420 billion according to a Texas-based hedge fund, Houndstooth Capital Management.
Overall, timing the market is extremely difficult and anticipating if volatility will revert to its mean or remain low for an extended period of time is an absolute guessing game. Although the short VIX trade continues to gain popularity, the strategy remains extremely risky. Investors looking for a high risk-reward investment strategy should focus on a small-cap approach, which KeyStone specializes in. Not only will you take on less risk, the upside potential can be far more lucrative.
