Is volatility dangerously oversold? In their November 2017 paper entitled “Everybody’s Doing it: Short Volatility Strategies and Shadow Financial Insurers”, Vineer Bhansali and Lawrence Harris survey strategies that directly or indirectly short volatility, including:
- Relevant strategies (selling options, buying and selling products linked to volatility indexes, risk parity, risk premium harvesting and volatility targeting).
- Types of investors that use them.
- Commonalities among them.
- Implications of commonalities (correlated unwinding).
Based on the properties of these strategies, they conclude that:
- Short volatility exposure is pervasive across investor horizons:
- Long-horizon sovereign wealth funds, public pensions and endowments systematically sell volatility (for example, by selling options) to capture the associated risk premium. They are unlikely to curtail or cover volatility shorts except during market stress.
- Medium-horizon (three to five years) investment managers also sell volatility to augment returns. In addition, those managers following risk parity, risk premium harvest and volatility targeting strategies implicitly short volatility by systematically: (1) leveraging low-volatility assets; (2) accepting risk from hedgers; (3) hedging by selling (buying) index futures when volatility rises (falls).
- Short-term trend followers often also implicitly short volatility via volatility targeting and volatility scaling rules. Others short volatility directly via ETFs/ETNs based on VIX futures to participate in demonstrated (and recently dramatic) high positive returns and Sharpe ratios. Market makers sell far out-of-the-money options to manage overall time decay and volatility exposures.
- Aggregate total investment in strategies that directly or implicitly short volatility is over $1.5 trillion and growing across asset classes.
- Investors are likely unaware of the extent to which the above strategies are correlated and mechanized, such that uncoordinated behavior could trigger a significant volatility event. Specifically, a jump in implied volatility would likely cause many of the above investors to sell.
In summary, rapid growth in strategies that directly or implicitly short volatility across asset classes creates conditions that may trigger uncoordinated but correlated, self-reinforcing liquidations.
The authors warn but do not predict or test any metrics for signaling danger, leaving investors to decide whether continuing to short volatility is worth the risk.
