VIX Surge Is Unwelcome Lesson in Duplicity of Volatility Wagers

  • Short volatility trade takes a hit after months in the green
  • Long volatility trade pays out but only for astute timers

The Short Volatility Trade Takes a Hit

It finally happened.

After months of speculation over when the lull in U.S. equity volatility would snap, investors got their answer Wednesday. A bombshell report on President Donald Trump’s interactions with former FBI director James Comey sent the VIX up the most in almost a year.

For anyone on the wrong end of the trade, it was a painful lesson.

Investors who had been minting money since Election Day by selling volatility, taking a short wager on equity-market turbulence, got a reminder of how fast the bet can turn. Stuck for weeks at its lowest levels in a decade, the CBOE Volatility Index surged by almost half in a matter of hours.

Betting on muted volatility was all the rage as the VIX went dormant below 11 for almost a month. There’s about $1 billion in bearish positions in VIX short-term futures exchange-traded products, and total exposure to a one-point jump in the VIX has been in the $300 million to $500 million range since 2014, according to an estimate from Macro Risk Advisors.

As analysts at MRA note, a long position on volatility is hard to stomach when looking at a chart of the VXX exchange-traded note, which grinds lower over time due to the cost of carrying a rolling position in front-month VIX futures that comprise the underlying securities of the ETN.

It’s tricky on the other side, too.

Investors who got paid Wednesday betting on a jump in volatility had very little room for error, given the downward bias in the short-term futures product. For example: if you had predicted Wednesday’s meltdown a month ago, a long trade on VXX still wouldn’t break even after the 18 percent surge in the note. Instead, you’d need a 28 percent jump.

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