Before bitcoin grabbed all of the headlines this November, a widely talked about trade in 2017 had been the short-volatility trade. One popular trade investors have used to monetize the low volatility environment, XIV, has gained almost 200% this year. Although these returns don’t stack up with bitcoin’s run in 2017, the fundamentals driving short-volatility strategies are much clearer. But before discussing why the past year has been supportive of short-volatility strategies, I want to discuss two types of strategies first.
One strategy is to sell an option and delta hedge. This strategy hopes to monetize the difference between implied volatility and realized volatility. Another way to think of this is to imagine implied volatility is the price at which you sold the optionality to the buyer, and realized volatility is your cost from buying and selling the underlying asset to offset the exposure you have to the asset’s price from selling the option. If implied volatility (the price you sold optionality) is consistently higher than realized volatility (the cost of providing the optionality), the trade will perform well. As you can see in this week’s chart, realized volatility has been much lower than implied volatility throughout 2017.
A second strategy is to short the VIX via futures. The VIX is a measure of the market’s current estimate of future short-term (under three months) volatility based on a weighted average of the implied volatilities on near-term S&P 500 options. VIX futures, then, measure the market’s future (at the settlement date) expectation for future short-term volatility. This week’s chart also shows expectations for rising volatility continue to get pushed out further. The VIX futures curve has spent the majority of the year in contango – a state where the VIX futures price curve is upward sloping and higher than the current VIX level. When you sell a VIX future with the curve in contango, it will “roll down” the futures curve and you can buy it back or let it settle in the future at a price lower than the price you sold it. This trade performs better the steeper the VIX futures curve is because the roll down is larger.
The low-volatility environment in 2017 has been talked about hand-in-hand with the current “Goldilocks” economy that is neither “too hot” nor “too cold.” Stable levels of global growth and inflation have lowered the uncertainty surrounding central banks’ actions as they begin to slowly and gradually tighten monetary policy. The perceived likelihood of a hard landing in China as it rebalances its economy has fallen as well. Additionally, political uncertainty this year has been much more muted compared to 2016, when Brexit and the U.S. election increased market volatility. The reduction in uncertainties has allowed a risk-on tone to persist all year and kept realized volatility low and pushed expectations for increased volatility out further in time. Within equities, inter-sector correlations have fallen sharply due to sector rotations such as “cyclical versus defensive” and “growth/tech versus value/financial/energy.” Correlations and volatility tend to increase during risk-off periods.Key Takeaway
A very benign economic and political backdrop in 2017 has allowed short-volatility strategies to perform well this year. Some opponents to the strategy have characterized it as a crowded trade that will unwind sharply and painfully. However, the relative spread between implied and realized volatility is at near-term highs and the VIX futures curve remains in steep contango. For now, the economic and political backdrop will continue to support short-volatility strategies. I will be keeping an eye on changes to this backdrop in 2018 that would affect my outlook for this trade.
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