Volatility: To trade or not to trade?

Investors have been making a beeline for trading volatility this year. But doing it is not as easy as it seems, writes Sarfraz Thind.

Volatility is back on the table. After one of the most muted years on record, with the VIX—the Chicago Board Options Exchange (CBOE) volatility index—hitting record lows, August has seen an increasing numbers of spikes in volatility coupled with a seemingly large amount of pre-positioning for rising volatility.

But trading volatility is no simple matter. Getting exposure to an index like the VIX remains challenging and views on trading it are mixed. So what should an investor seeking to exploit this benchmark be aiming to do?

The popularity of trading volatility has never been higher. Futures and options volumes on the VIX have been skyrocketing in 2017. The current year has already recorded four of the ten all-time busiest trading days in VIX futures, while both options and futures had their busiest ever trading day in August.

Undoubtedly the major trade of the year has been shorting volatility. The interest in this comes against a background of unusually low levels of the VIX. The index, which remains the most looked-at gauge of volatility in the market, has been hovering around 12 for much of the year—compared to the average of around 16 last year—and dropped to historical lows of 9.36 in July. The low levels have puzzled some commentators given the potential for turbulence from recent macro and political events.

“It is very unusual having the VIX at historic lows,” says Tom Lehrkinder, a senior derivatives analyst at TABB Group. “It is really perplexing with everything going on in the US and North Korea and Brexit. You would think the instability would kick off the VIX. Instead of being at new lows it should be at new highs. Maybe the VIX is not the right instrument but the VIX is the only game in town right now.”

Others believe the VIX has been a reflection of the slow and staid underlying financials of the global economy and the lack of action on interest rates that has characterised financial markets for the better part of a decade now.

“The macro outlook has been positive,” says Russell Rhoads, director of education at CBOE’s Options Institute. “We have seen a continued slow improvement in the economy and the odds of a rate hike have been taken off the table and pushed back to 2018 which could account for the low realised volatility. It is currently a Goldilocks economy, but we could be near the end of it.”

In any respect the continued decline of volatility has provided a goldmine for investors pursuing the short volatility trade. Spikes have been followed by a sharp move back down as short sellers have come in to dampen volatility levels, rather than seeing the heightened risk reaction more typical in the past. Investment in the XIV inverse short-term VIX futures exchange-traded note (ETN) by Velocity Shares would have netted some 118% in the last year. It is a contrast to going long volatility in expectation of it rising. The Barclay’s Bank VXX—one of the most popular long VIX ETNs in the market—has dropped 67% in the last year and some 99% since inception.

But while volatility has bounced along at historical lows a confluence of factors has revived fears the market could turn in the third quarter. Indeed, it is the fear of heightened volatility that appears to be one of the most urgent motivators for trading. VIX index levels spiked 44% to close on 16.04 on August 10 when the potential for a US and North Korea conflict blew up with threats of “fire and fury” and possible missiles being launched in the Pacific. And the jump in derivatives trading volumes were even more striking. The day saw 939,000 VIX futures traded—trouncing the previous record of 791,000 in 2014.

The fear of rising volatility has prompted unusual trades in the market. In the last few months talk has focused on an investor dubbed “50 Cent.” The investor has bought 50,000 VIX call options worth around 50 cents on an almost daily basis on the premise that volatility will spike at some point. The fact that this has not happened in any grand scale is thought to have cost 50 Cent some $75 million so far, according to analysts. Yet, despite the returning fear in the market, getting perfect exposure to the VIX remains a tricky challenge.

Harvest Volatility Management, one of the larger pure volatility funds in the market, has been a seller of volatility this year—but not using VIX options or futures. According to Rick Selvala, chief executive of Harvest which has around $9 billion in assets under management, the VIX is not the optimum benchmark for trading volatility.

“The VIX is low but it is not necessarily cheap,” says Selvala. “When the VIX is at 10 realised volatility will be at 5 or 6. We don’t trade the VIX—our focus is on index options on the S&P 500. That is the deepest and most liquid market so the liquidity cost is minimal. Rolling down the VIX curve can be tricky. The VIX takes the delta component out of the equation but VIX derivatives are less liquid and more able to be manipulated. VIX is a reference for us not a driver.”

Stefan Rondorf, senior investment strategist at Allianz Global Investors, agrees: “The VIX is a kind of mathematical construct,” he says. “While buying protection is relatively cheap from a historical point of view, you don’t get it for free.”

Using rolling VIX futures creates a negative cost of carry as forward months are priced higher than near months meaning investors have to pay more to roll over their positions from month to month. At the same time the futures contract will only imperfectly track the underlying VIX index. While the VIX spiked 44% to close on 16.04 on August 10th, short-term futures rose to a high of 15.55.

“The idea is that traders believe that any spike will come down quickly so there is a futures discount,” says Rhoads.

There are other ways to trade the VIX. The aforementioned ETNs have been popular in recent years—though these are potentially even less efficient then trading the futures contract.

“VIX ETNs, levered and inverse, those are more of an unknown,” says Selvala. “What will happen when markets go haywire? These products are forced to buy more as it gets higher. We have not seen the full effect of these, right now they are still small.”

The issues with the VIX have led to participants calling on use of other benchmarks as a better gauge of volatility.

Last November, Hyun Song Shin, head of research at the Bank for International Settlements, said the dollar was a better gauge of bank leverage than the VIX. Meanwhile exchange operator Bats Global Markets issued a new volatility index linked to S&P 500 SPDR ETF issued by State Street which it has called more “rigorous and dependable” than the VIX. It is relevant because it seems that the volatility trade could get even busier later this year.

“We have been in the lowest period of realised volatility since we have had the S&P500,” says Rhoads. “The market is in a very riskless environment right now, but from a historical or seasonal perspective, the third quarter is when many volatility events happen. The trading activity we’re seeing now could be investors beginning to get out of short volatility trades.”

It is likely to be an interesting time making the right instrument choice all the more important.