Why Everyone’s Trading Volatility

Does a question about the VIX over a 4th of July weekend barbecue count the same as the shoeshine boy giving stock tips?  We’re not sure it’s quite the same… it was an innocent question about what the VIX is… not a full-on treatise on how to trade it, but the evidence keeps mounting that more and more investors are trading the VIX these days, now seeing the fear gauge as a tool to generate returns, not just an indicator. Whether we’re in peak VIX mode or not – it was high time we wrote a whitepaper on all the ins and outs of volatility trading via the VIX – read it here.

There’s roughly $4 Billion invested in volatility-based strategies via exchange traded products (i.e. ETFs), with about half of that on the short volatility side, led by the most popular short vol ETF, $XIV, with roughly $730 million in AUM. All of this is being led by the rush to create a product by Wall Street and the incredible shrinking levels of the VIX index itself, which seemingly crashes back to lower levels faster than the time before after every rise in volatility.

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This has led to an increasing amount of so-called “smart money” (hedge funds and large speculators) building up an almost always short VIX futures positions, as represented by the recent CFTC commitment of trader’s report:

So – it seems easy enough, load up on the short VIX trade and enjoy the constant reversions to the mean. After all, the VIX is a mathematical formula, not an index of stocks or commodities like other investable asset classes. As Brett Nelson of Certeza Asset Management, who runs a quant program focused entirely on creating alpha from the VIX and volatility-based strategies says, the VIX trending up over time like a stock index is “mathematically impossible.”

You’ve got an instrument that cannot indefinably trend one direction, mathematically. It could stay at a higher lever for a sustained period. If someone were to say the mean of the VIX is somewhere around 15, it doesn’t have to revert to that 15 all the time. It can go down to 10 or below and it could hang around 20 for a while. But the idea that it would act like an equity index – that it would trend higher and higher with inflation and other market forces is mathematically impossible. We cannot be in a period where year after year after year, investors are bidding up the price of puts, because everyone would simply stop buying puts. It would no longer provide a protection for a portfolio.

But there’s always the possibility of that spike which wipes out the constant reversions to the mean, and the little problem of what happens when there are more people selling volatility than there are buying it for protection. What happens when the tail is wagging the dog?

We get into all of that and more in our new whitepaper highlighting investing in the VIX through ETFs, VIX Futures, and Hedge Funds (including how Mark Cuban, was sort of responsible for the creation of the VIX tracking products). Click here to download our whitepaper outlining everything you need to know about VIX investments/trading.

Article by RCM Alternatives