The Big (Volatility) Short

By Lawrence G. McMillan

One of the most successful investment strategies practiced by hedge funds (and other sophisticated investors) in the last ten years has been the “volatility short” trade.  It is rarely mentioned on TV or in the media, but that is not too surprising.  They would rather promote things such as the “Japan carry trade,” which wasn’t necessarily a profitable strategy at all unless a great deal of risk was taken.  Not to say that the “volatility short” didn’t have its own share of risk, but it’s a lot more certain to profit if a certain status quo is maintained. 

In this article, we’ll look at the history of the “volatility short” trade and see where it stands today.  The long-term perspective on this trade may be a bit surprising, for it shows the tremendous toll that the $VIX futures premium takes on a long volatility position.

Background

$VIX futures were first listed in 2004.  They had really been planned to launch in 2003, when the “old” $VIX – based on $OEX options – was replaced by the “new” $VIX, based on $SPX options.  However, there was a problem designing the $VIX futures so that market makers could hedge them with a relatively easy degree of simplicity.  Without the ability for market makers to arbitrage their positions (i.e., hedge them “perfectly”), no market will attain a high degree of liquidity.  The design that the CBOE came up with is the same one we have today: the futures are based on the one strip of $SPX options that expires 30 days after the futures themselves expire.  This has indeed provided the framework for market makers to hedge themselves, and hence the $VIX futures market is a liquid one...

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