Federer, Chainsaw, and Russian Roulette: Lessons from the Recent Volatility Spike

2018-03-01

Having built a large long volatility position in the VIX exchange traded notes market in the first quarter of 2016, investors have been using every increase in implied volatility (Brexit, French elections, North Korea missile crisis) as an opportunity to sell volatility. As a result, many investors have ended up short volatility, either explicitly via short volatility products or risk premia strategies, or implicitly via quantitative strategies (risk parity funds, vol targeting funds) that use the level of volatility as an input for allocating into risk assets.

For years, my colleagues at Dominicé & Co and I, along with other experienced volatility managers, have been arguing that there is too much complacency among investors who blindly sell volatility as a way to fight the low rates environment.  On February 5th, those trades were washed out in a spectacular manner.

What lessons are there to be learnt?

  1. Small is beautiful

In difficult and choppy markets, a smaller operator can be quicker in turning its position around. This is especially true for an asset, such as volatility, that can experience large swings. This is also true in today’s markets, which have become more fragile, because of excessive regulation in recent years of banks and exchanges.

  1. 50 shades of Vol

It is better to take a straightforward risk with a few listed vanilla instruments, rather than with a large book of complex trades that are really 50 shades of the short vol play where the risk will converge on the way down and will take longer to unwind.

  1. So you think you’re Federer?

Many people have seen Federer play but very few can do what he does.  Similarly, volatility trades in back-tests  may look like easy money to a junior quant, but, when these go south, expertise and experience make the difference.

  1. Beware of the falling knife

Selling volatility spikes works, until it doesn’t. Buying equities in a correction is like catching a falling knife, but selling volatility on a spike is like catching a chainsaw. Because volatility has no maximum, you risk a lot more than a simple flesh wound.

  1. Russian roulette

Systematic short sellers have been making the point that there is a structural imbalance in volatility supply, that there is no point trying to time or manage the trade, and that investors should not only accept drawdowns but use them to pile on the trade.  But they don’t see the game and what they are doing is playing Russian roulette.  The downside can be catastrophic. You can recover from a downturn in equities, but you cannot recover from a catastrophic loss in a short vol trade that wipes out over 90% of your investment.

These lessons are not new. Over the years, investors have learnt them painfully but have chosen to forget them quickly.

The good news is that the chance to put these lessons into practice may come soon, before they are forgotten again.