As the markets sold-off in February with the steep rise in option volatility, there was an exceptional amount of VIX futures purchased, which potentially contributed to the sell-off in S&P futures during that time. The lack of liquidity for VIX futures in the after-market session highlighted the “fragility” of these types of strategies which suffered steep losses. In and of itself, shorting volatility is not a “bad” thing and there are numerous studies and strategies that employ risk premium harvesting to add incremental returns to portfolios. However, shorting volatility while using excessive leverage can quickly become challenging to manage under times of market duress.
A Regime Change?
And what about realized volatility? Well, realized volatility spiked as well. Risk premia harvesting strategies are based on the premise that over time implied volatility trades higher than what is actually realized in the underlying market. The early February move lower, by one metric, was one of the largest 5-day percent increases in history. The only other times that witnessed greater 5-day realized volatility percentage increases were May-1940, German blitz; May-1948, Israel independence declared; and October-1987, Black Monday crash (Source: Bank of America Merrill Lynch).
What does all this mean going forward? In previous writings, we’ve made the case that volatility tends to trade in “regimes”—i.e., low-vol, mid-vol, and high-vol environments. Undoubtedly, 2017 was a low-vol regime. However, a tremendous amount of short-gamma is now out of the market. The catalysts for another spike in the VIX of the likes just witnessed have been diminished, at least in the near-term. Market sell-offs from this point should be more “orderly” in keeping the VIX in its new volatility regime.
As we can see from the graphs below, the start of 2018 for the VIX looks quite similar to that of 2007 when the 2004–2006 low volatility period came to an end.
Throw in tax cuts, tariffs, and possible trade wars, don’t expect the VIX to see single digits anytime soon.
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