A Popular Option Trade Returns in 2024 as Hedge Funds Short Volatility
The “short volatility trade” is making a comeback in 2024. The move involves wagering on reduced volatility, typically via VIX futures. In 2018, this same trade significantly backfired on investors causing a “Volmageddon,” inflicting severe losses as market volatility surged unexpectedly.
What is the Short Volatility Trade?
In 2023, the “short volatility trade” re-emerged as a major moneymaker in the options market as traders capitalized on the subdued movements in the Cboe Volatility Index (VIX).
This approach, which entails betting against short-term futures linked to the VIX, also known as Wall Street’s “fear gauge,” gained traction due to the relatively stable market conditions.
The VIX, which predicts market volatility by analyzing S&P 500-linked options, is a barometer for how volatile investors expect the market to be. Last year, this index often traded below its long-term average, a trend that was interrupted only by sporadic spikes. The consistently low levels of the VIX indicated an expectation of minimal market fluctuations, making the short volatility trade particularly profitable.
Investment analysts specializing in equity derivatives noted that such a strategy effectively generates returns, especially in a market that neither climbs nor falls significantly. Traders can engage in this trade by using call or put options or directly buying or shorting futures contracts tied to the VIX.
A key driver behind the success of the short volatility trade in 2023 was the lack of significant daily swings in the S&P 500, which hadn’t experienced a 2% movement in either direction for over six months, marking one of the calmest periods in the past 25 years.
The short volatility trade’s appeal also stemmed from the few instances where the VIX experienced sudden, albeit brief, increases. These moments provided lucrative opportunities for investors to bet on a quick return to lower volatility levels.
The “Volmageddon” in 2018 Resulted in Billions of Dollars Lost
While it has repeatedly proven effective in generating substantial returns, the short volatility play entails extreme risk. This is particularly true for investors who use significant leverage or ignore hedging their positions.
Many traders found this out the hard way on February 5, 2018, when a sudden spike in the VIX caused a “Volmageddon.”
The index soared from about 20 to 40, sending US stocks plummeting and resulting in a record decline in the Dow Jones Industrial Average (DJIA). This market shock, primarily driven by rising Treasury yields and concerns over an overheating US economy, was intensified by the crowding in short-volatility exchange-traded funds (ETFs).
As these funds scrambled to cover their short positions in Vix futures, the market experienced a widespread meltdown. The chaos led to suspending trading in VIX-linked ETFs, resulting in billions of dollars in investor losses.
Do you think the short volatility play can backfire once again for options traders as it did in 2018? Let us know in the comments below.
Disclaimer: The author does not hold or have a position in any securities discussed in the article.
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