Monday, March 20, 2017

The Case for Short Volatility

Before even whispering ‘short volatility,’ we should ask “what is the case to be long volatility?” to have a little context.  Fortunately we don’t have to look far for the long vol advocates, as 90% of articles, blogs, and charts can be summed up as “we are at the all-time high,” “10 charts that guarantee a correction,” “when will the rubber band snap,” etc etc.  Furthermore, all of these articles are written by the ‘contrarians,’ the ones who see the crash before it happens and who get short right at the top and cash in.  More specifically, the ones who haven’t gone broke being short yet.  The question becomes when is the inflection point, when the majority are contrarians, are they still really the contrarians?  How much Healthy Choice ice cream can we eat before it’s no longer a healthy choice?  Of course they are the directional contrarian, but no longer the sentiment contrarian, so which one really matters?

This brings me to what makes the market the purest intellectual challenge, it is two-sided and liquid.  If you think something is stupid, you can take the other side.  Almost nowhere else can we do that; if we think health, car, house insurance is overpriced, we can only take the losing side of that trade. In short vol land, we will definitely be wrong, very wrong, at some point; that is guaranteed.  The concept of future volatility being higher is the entire basis for volatility contago and why short vol trading works.  The entire reason insurance works is because the unforeseen does and will happen. 

However, for the other ~70% or more of the time when volatility is contracting and the short works, we get to be right and profitable.  Combined with the risk management of keeping ~50% or more in cash during low vol, we get to average down into vol spikes, and get the really good short premium scenario in high implied volatility.  If you read anything from any kind of options backtesting sites or blogs, the one consensus is that everything works in high IV.  The short vol strategy gets paid as long as you aren’t in this high profit zone, and then averages down into it once it arrives.
I plan to delve much further and have longer pieces on all of these concepts but this is just to dip into the broad concept of short volatility in all conditions. 

While this started as a joke, it has become ironic, then post ironic, then deadly serious- then a joke that is still serious.  I'll have many posts about the Fed, macro policy and how I see it fitting into short VIX.

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