Introduction: The Allure and Risks of Volatility Trading
In the ever-evolving landscape of financial markets, engaging in volatility risk premium harvesting programs has become increasingly attractive. The lure of higher profits, potentially eclipsing the S&P's benchmarks, has drawn many to this approach, now more accessible than ever due an increasing number of available instruments, often in ETF form. Take, for instance, major players like Softbank, who've become notable buyers of long call options in tech stocks, thus amplifying their exposure to tech beta. Intriguingly, the initial belief was that retail investors on platforms like Wall Street Bets were emulating Wall Street's strategies. Yet, in a fascinating twist, it's Wall Street that seems to be adopting the retail crowd's "YOLO" approach, chasing short-term gains with gusto. These market dynamics deserve a closer look, especially given the looming shadow of a potential doom loop scenario, reminiscent of the 2018 'Volmageddon'.
The Deceptive Calm of 2022: A Volatility Mirage
2022, a year marked by downturns in the stock market, surprisingly saw short volatility funds thrive. This success was due, in part, to the lack of significant spikes in equity volatility, even as volatility surged in rates and FX markets. The VIX, the barometer of S&P 30-day implied volatility, exhibited little fluctuation, reflecting this unusual stability. In a market devoid of major upheavals or panic, driving volatility higher becomes an arduous task, reducing the perceived need for insurance protection. Yet, the pre-Christmas drop in the S&P 500 serves as a cautionary tale, sparking debates on the influence of shorter-dated options on market dynamics.
A Five-Year Voyage: Profiting from Volatility Selling
Over the past five years, investors have adeptly navigated myriad challenges to reap profits from selling volatility. The sixfold growth in AUM of U.S. equity short volatility hedge funds since 2018 is testament to this strategy's success. Notably, selling straddles has emerged as a particularly lucrative method, often requiring minimal reliance on quantitative analysis. While market analysts ponder the impact of shorter-term options and day-to-day hedging preferences, the significance of 30-day and longer exposures cannot be overstated for informed and profitable decision-making.
The Warning Signs: Echoes of ‘Volmageddon’
Rewinding to January 2018, just before 'volmageddon' struck, there was intense focus on vega – the metric for financial impact from volatility shifts. Today, the net short exposure to vega is alarmingly double that of the pre-2018 era. Derivative income generating funds, thriving on volatility risk premiums, have seen their AUM soar tenfold, underscoring the growing allure and profitability of vega-centric strategies.
The Hidden Danger: Complacency in Short Volatility Trading
Yet, beneath the surface of these lucrative trades lurks a perilous trend: the increasing risk of complacency among market participants. Success in short volatility trades can breed a false sense of security, leading to riskier behaviors like enlarging positions or ignoring negative market signals, under the misguided belief in mean reversion's saving grace. This dangerous mindset is akin to "picking up pennies in front of a steamroller."
Conclusion: A Call for Vigilance and Understanding
Astute market observers are now sounding the alarm on the risks of this complacency, stressing the importance of vigilance and a deep understanding of the underlying dynamics. Investors, including seasoned professionals, often exhibit short memories, forgetting past lessons at their peril. As we navigate these turbulent markets, a keen awareness of the risks and rewards of volatility trading becomes essential for sustainable success.