Flood of Traders Betting Against VIX May See Big Losses Like 2018

Sometimes investors have short memories, and sometimes they believe that trends will continue indefinitely. The CBOE Volatility Index (VIX), which measures expected volatility in the S&P 500 over the next 30 days based on options trading, has fallen sharply so far in 2019, prompting a growing number of speculators to bet that it will remain low, The Wall Street Journal reports.

“Sentiment is incredibly bullish,” as Nancy Davis, chief investment officer (CIO) at Quadratic Capital Management, told the Journal. The VIX normally falls in rising markets and rises during selloffs, thus its popular moniker as a "fear gauge." The VIX plummeted by more than 50% from Dec. 24, 2018 to Jan. 18, 2019, among the fastest drops of this magnitude ever recorded, per research by Macro Risk Advisors cited by the Journal. From the close on Dec. 24, 2018 to the close on April 23, 2019, the VIX fell by 65.8%.

The table below summarizes some of the ways that investors can bet on declining stock market volatility, as measured by the VIX. This is called the "short-volatility" or "short-vol" trade, and requires the use of financial instruments who value is linked to that of the VIX, which itself is an index, and not a tradable financial product.

Some Ways To Make "Short-Vol" Bets

• Take short positions in VIX futures contracts
• Take short positions in VIX-linked products such as the iPath Series B S&P 500 VIX Short Term Futures ETN (VXXB)
• Take long positions in inverse volatility ETNs such as the ProShares Short VIX Short-Term Futures ETF (SVXY)

Sources: The Wall Street Journal, CBOE

Significance for Investors

A spike in the VIX during the big market selloff in Feb. 2018 caused massive losses for short-vol speculators. Losses estimated at $420 billion followed a subsequent one-day surge in the VIX during Oct. 2018.

The popularity of the short-vol trade had spawned the development of inverse volatility exchange-traded products (ETPs) whose prices would move in the opposite direction of the VIX, rising when the VIX fell and falling when the VIX rose. Those making short-vol bets could take long positions in these products rather than short other ETPs that rose or fell in concert with the VIX.

Most notably, the VelocityShares Daily Inverse VIX Short-Term Exchange Traded Note (XIV) lost 94% of its value in just over an hour's trading on Feb. 5, 2018 in the wake of a soaring VIX. Its issuer, Credit Suisse, liquidated the product pursuant to a contractual provision, as described by Investor's Business Daily. A similar product, the ProShares Short VIX Short-Term Futures ETF (SVXY), also fell by more than 90% on the same day, per the same report.

While the risks are high, it is possible that the short-vol trade can be a profitable form of speculation going forward. This would depend on the persistence of a benign environment for equities in which inflation and interest rates stay low, the economy continues to expand, and the worldwide geopolitical scene is devoid of major crises.

Looking Ahead

Even if expected stock market volatility, as measured by the VIX remains low, investors should realize that turning a profit from short-vol bets may be impeded by high costs. For example, the predecessor to the VXXB ETN, the VXX ETN, lost 99.96% of its value since inception due to costs, per calculations by FactSet Research Systems. As a result, the prospectuses for such products often warn that they are unsuitable as long term investments.