Is Shorting Volatility a Free Lunch?

Thinking about shorting volatility? You’re not alone.

Short interest in the long volatility ETN (VXX) has exploded higher in recent months.

Image of Short interest in the long volatility ETN (VXX) reaching new heights in recent months

Source: RBC, Zerohedge

Why does everyone want to short vol?

1) Shorting volatility (ex: shorting the long volatility ETN VXX) has been enormously profitable since 2009…

Total retuns graph of Long Volatility since 2009 to 2017

2) This week the Volatility Index (VIX) hit its lowest level since December 2006: 9.56.

Image of Volatility Index hitting its lowest level since December 2006

3) On a closing basis, only a few days in late December 1993 have seen lower levels…

Table showing lowest daily closes of Volatility Index since 1990 to 2017

4) Over the past 13 trading days, the S&P 500 has traded in a range of 1.01% (high to low as a %), the lowest 13-day trading range in history.

Graph showing S&P 500 13-day range from high to low since 1970 to 2017

5) The Short Volatility ETN (XIV) is up 735% since its inception in November 2010 versus a gain of 130% for the S&P 500 (SPY).

Image of returns since inception of the short volatility ETN in November 2010

So is shorting volatility a free lunch?

While the many newcomers to the trade likely believe so, anyone who’s been involved in markets longer than the past few months knows it is anything but.

Shorting volatility is somewhat equivalent to a highly leveraged bet on the S&P 500. When the S&P 500 goes up, volatility tends to go down, and shorting volatility tends to make money. When the VIX is in contango (2nd-month futures are higher than front month futures), as is often the case, shorting volatility via ETNs like VXX provides an additional return via the roll yield (see my post here for more detail on that).

As we saw in the charts above, we’ve been in one of the lowest volatility periods in history, and VIX futures have been in a state of contango for much of this time. This has led to an almost vertical run-up in the short volatility play (XIV), particularly since the market lows after Brexit.

But a free lunch it is not. With annualized volatility of 64% since inception (vs. 15% for the S&P 500), you are very much paying the price for any higher return with much higher volatility. And even in the low volatility environment since 2010 when XIV launched, it experienced a 74% drawdown in 2011 and a 68% drawdown from 2015-16. Should a more extended bear market ensue (the 2011 bear was shallow and short-lived), a 90+% drawdown would not be unexpected.

Comparison between Max drawdown of Short Volatility and S&P

Is a sharp decline for the short vol bet on its way? You can count on it; it’s not a question of if but when. With the VIX hanging around 10, a volatility spike is inevitable. And given the extremely low levels today, even a move back to the high teens in the VIX (the historical average) will feel like a crash. When that move occurs, those lining up in recent weeks to grab the supposed free lunch will learn the hard way that there is no such thing in markets. A price will be paid – if not today then in the future – but it will be paid.

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This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.



Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts.  He is the co-author of four award-winning research papers on market anomalies and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors and previously held positions as a Credit, Equity and Hedge Fund Analyst at billion dollar alternative investment firms.

Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.

You can follow Charlie on twitter here.


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