Why the Short Volatility Trade Is Back and Bigger Than Ever

Tracy Alloway (0:10)

Hello, and welcome to another episode of the Odd Lots Podcast. I'm Tracy Alloway.

Joe Weisenthal (0:14)

And I'm Joe Weisenthal.

Tracy Alloway (0:16)

Joe, do you know what's coming up?

Joe Weisenthal (0:20)

The Odd Lots Pub Quiz.

Tracy Alloway (0:21)

That's true. Also Valentine's Day, I guess.

Joe Weisenthal (0:25)

Oh, yeah, that's a little bit later on. What else do you have in mind, Tracy?

Tracy Alloway (0:29)

Do you celebrate the anniversary of Volmageddon?

Joe Weisenthal (0:32)

Do I celebrate it? Yeah, I mean, gee, who doesn't? No, I don't celebrate it, but that was such a formative moment, so that was February... when was the day?

Tracy Alloway (0:41)

2018, so it's the sixth year anniversary.

Joe Weisenthal (0:43)

That was one of our first really good episodes, where we sort of had a good... we talked about what blew up the short Vol ETF, XIV. I feel like if we go back through our history, that was an important episode.

Tracy Alloway (0:56)

Wait, don't say that was one of the first good ones, because we were doing this for years before 2018

Joe Weisenthal (1:01)

You're right, we've had many good ones. I think that was a good one.

It was a highlight.

Tracy Alloway (1:05)

It was a highlight.

Joe Weisenthal (1:07)

Okay.

Tracy Alloway (1:09)

Well, I do in fact celebrate the anniversary of Volmageddon, because I always enjoy going back to tweets around that time, because there are a lot of volatility traders on social media who have very strong and often erroneous opinions. And one of the opinions they were holding around January 2018 was that everything was fine, shortfall was this perpetual moneymaker, no issues with the two volatility exchange traded notes that eventually ended up blowing up, one of which was XIV, as you pointed out. And I remember tweeting things in January of 2018, stuff like if the VIX curve inverts, which was about to happen, this would be an absolute disaster for XIV. And I had a bunch of people pushing back, complaining about the access on my chart.

And lo and behold, about a week later, XIV not only blew up, but was dead within a couple of days and actually roiled the market as well.

Joe Weisenthal (2:09)

I remember it was very popular, XIV, this vehicle. And there was a sound intuition about it, I think, which is that, you know, is this basically betting against the VIX. And you start with the assumption that, okay, people systematically and perpetually overpay for downside protection.

Understandable, people pay for insurance. And so you can harvest that premium, basically, by taking the other side.

And that by and large, shorting vol is a sort of like a good way to, a way that people supercharge their returns. And look, like a core thing is that when we talk about vol, I think like we are mostly in life short vol. Anyone who owns stocks for a long period, or any period is short vol, we're sort of like vol is bad for portfolios, et cetera. So like when we talk about specifically shorting vol though, then that's where it gets interesting.

Tracy Alloway (3:02)

Yeah, so this is one of the things that I find very remarkable about our current moment, which is that shorting vol post the 2008 financial crisis became a very popular strategy because you had low interest rates. So people wanted to pick up yield wherever they could. You also had central banks out there in the market, literally crushing volatility. So you knew that there was the put that sort of existed over the overall market. So why not try to monetize it? There wasn't a lot going on up until 2018 So it made sense to bet on nothing, basically, on things not happening.

But what I find really fascinating about the current moment is we seem to be seeing a return of that short volatility trade. So you and I have discussed on this podcast these shorter dated options, one or zero dated options becoming incredibly popular, absolutely exploding in terms of volume. There's other types of derivatives that are also becoming more popular.

And yet, when I look around at the market, it seems like there is so much potential for one-off events. The Fed is hiking rates. We have geopolitical risk, as we always talk about, joke about on the show, supply chain disruptions. But the chance of one-off events actually happening seems greater than ever. And yet, shorting vol is popular, and measures of vol itself remain pretty low. The VIX is pretty low, the volatility of the VIX index, the VIX is really low. So I think we need to ask, why is short vol back?