Everyone knows that the stock market is volatile. So it should be a no-brainer to make a bet that volatility will continue to do what it’s been doing for the last 20 years – spike. But betting on volatility is tricky. In fact, most investors get it wrong and end up losing money. How does a volatility bet work, and is there a way to make money at it?
Fear is good business on Wall Street. For starters, fear helps to encourage impulsive and emotional decisions on the part of retail and institutional investors alike. It is contagious, capable of spreading extremely quickly and can sometimes appear to be unbounded.
Fear also has been responsible for the development of a wide range of structured products tailored for institutional investors who wish to protect principal, minimize volatility and take other steps to counteract potential risks. The ugly side of fear is that it impels many people to sell at the bottom and wait to get long until markets are near a top.
These are all good reasons to want to sell fear, but not why I choose to do so. No, I am short fear because fear is almost always overpriced – and by a large margin.
Consider the Chicago Board Options Exchange Volatility Index, better known by its ticker symbol, VIX. Sometimes referred to as the fear gauge, the VIX is a market-based estimate of volatility for the next 30 days and is derived from prices on options on the Standard & Poor’s 500 index.
How accurate is the VIX? In the 23 years of historical data, the VIX has overestimated future volatility by an average of more than 27%. Incredibly, the VIX has overestimated future volatility by at least 10% in 22 of those 23 years. The one exception was 2008—when each catastrophic disaster seemed to morph into even bigger threats. But even in the worst financial crisis since the 1930s, the VIX underestimated actual volatility by a mere 5%.
As daunting as those statistics may sound to an investor who is considering the possibility of a long volatility position, it turns out that the products available for executing a long VIX strategy make the odds even more formidable. This is due to the fact that VIX futures, options and exchange-traded products such as the popular Barclays Bank iPath S&P 500 Short-Term Futures exchange-traded note (ticker: VXX) and the VelocityShares Daily 2X VIX Short Term ETN (TVIX) are priced on the basis of VIX futures.
It turns out that 75% to 80% of the time, the VIX futures are in an upward sloping term structure curve such that the more distant futures are priced higher than their near-term counterparts, a situation known as “contango.” Each day the products based on VIX futures that are in contango lose value commensurate with the difference in the price of the futures contracts. For products such as VXX, the effect of contango is frequently as high as 1% per week or more.
The 27% volatility (or variance) risk premium and the 1% per week net-asset-value decay due to contango make it extremely difficult for investors to structure trades that will benefit from increasing volatility, and yet have a positive mathematical expectation. Even with academic papers and all corners of the media educating investors about the pitfalls of long volatility positions, these trades remain popular and losses continue to pile up, particularly for retail investors.
While there are ways in which to minimize the odds of losing money with long volatility positions, for the most part investors will be better served by making use of short volatility positions with defined or limited risk, such as VIX futures or options spread trades. In these trades, the volatility risk premium and contango are much less of an issue and can even serve as a tailwind instead of a headwind.
When fear drives decision-making, the results are rarely good for the bottom line. If investors make it a habit to sell fear, however, they may be surprised to discover how profitable it can be to short something that is almost always overpriced.
(Author: Bill Luby, a veteran volatility trader who publishes the VIX and More blog http://vixandmore.blogspot.com/)