The Volatility Bet That Backfired: Billions Lost as Investors Underestimated Market Risks

A wager that stock markets would remain calm has cost retail traders, hedge funds, and pension funds billions after a global stock market selloff. The CBOE VIX index, a measure of market volatility, posted its largest-ever intraday jump, highlighting the risks of piling into a popular bet against volatility.

Uncovering the Perils of Betting Against Market Volatility

The Rise of Short-Volatility Trades

In recent years, the popularity of trading strategies that bet against market volatility has surged. Investors, including hedge funds and retail traders, have been able to take daily bets on short-term equity options, known as zero-day expiry options, which allow them to collect premiums as long as volatility remains low. These trades, often based on covered call strategies, thrived as the S&P 500 rose over 15% from January to July 1, while the VIX fell 7%.However, this strategy's success was short-lived. The sudden market selloff on August 5th, driven by fears of a U.S. recession, triggered a sharp position unwind, wiping out trillion from global stocks in just three weeks. Investors in the 10 largest short-volatility exchange-traded funds saw .1 billion in returns erased from their highs earlier in the year.

The Role of Hedge Funds and Pension Funds

The short-volatility trade not only attracted retail investors but also garnered the attention of hedge funds and pension funds. JPMorgan estimated in March that assets managed in publicly traded short-volatility ETFs totaled around 0 billion. Some hedge funds were also taking more complex short-volatility bets, playing on the difference between low volatility on the S&P 500 index and individual stocks that had approached all-time highs in May.According to data from hedge fund research firm PivotalPath, the 25 funds it follows that trade volatility, representing about .5 billion in assets under management, lost 10% on August 5th. The total group, including both short and long volatility positions, had a return of between 5.5% and 6.5% on that day.

The Role of Banks in Dampening Volatility

Banks have also played a significant role in the short-volatility trade. The Bank for International Settlements suggested in its March quarterly review that banks' hedging practices have contributed to keeping the VIX, the market's fear gauge, low. When clients want to trade price swings, banks hedge these positions, buying the S&P 500 when it falls and selling when it rises, effectively "dampening" volatility.Additionally, some banks have offered complex trade structures that include both short and long volatility positions, with the potential to expose investors to higher losses as the VIX spiked on August 5th. These structures may not have had a constant hedge built into the trade to protect against losses, leaving investors vulnerable.

The Cycle of Complacency and Losses

The short-volatility trade's popularity highlights the cycle of complacency and losses that often accompanies such strategies. When markets are near all-time highs, as they were earlier this year, investors, both retail and institutional, become complacent and start selling volatility for the premium. However, when an exogenous factor, such as recession fears, causes a market selloff, those who were short on volatility are hit with significant losses.As Michael Oliver Weinberg, a professor at Columbia University and special advisor to the Tokyo University of Science, aptly stated, "It's always the same cycle. Some exogenous factor causes markets to sell off. Those that were short vol will now be hit with losses."The recent market turmoil has served as a stark reminder of the risks inherent in betting against market volatility. As investors seek to navigate the uncertain economic landscape, they must exercise caution and carefully consider the potential consequences of their trading strategies, lest they fall victim to the same fate as those who underestimated the market's volatility.