As the U.S. stock market has rebounded from its recent low in Dec. 2018, so has the popularity of a risky bet that wiped out many speculators one year ago. The so-called "short volatility," or "short-vol," trade is premised on expectations that stock market price fluctuations will be low. So far in 2019, an ETF designed to mimic the short-vol trade has beaten the market by a wide margin, after falling much more sharply than stocks in the last quarter of 2018, The Wall Street Journal reports.

“Momentum has driven the market,” as Mohit Bajaj, director of ETF trading solutions at WallachBeth Capital, told the Journal. “Whenever something moves in such extreme ways, it’s tough to gauge if the run will continue,” he added. The table below looks back at the unraveling of the short-vol trade from Feb. 5 to 8, 2018.

The Risks: Short Volatility Bets A Year Ago

  • Dow Jones Industrial Average (DJIA) fell a record 1,175 points in one day
  • The Dow plunged 6.5% across four days
  • Massive unwinding of short-vol trades sent volatility soaring yet higher, and made the market decline longer and deeper

Source: The Wall Street Journal

Significance For Investors

The widely-followed CBOE Volatility Index (VIX) measures anticipated price swings in the S&P 500 Index (SPX) during the next 30 days, based on options trading linked to the S&P 500. It tends to rise when the market is down and fall when the market is up, and is often called a "fear gauge" for the market.

While the VIX is not a product that investors can trade, there are various options and futures contracts linked to its value. Hedge funds are prominent among the speculators that seek to profit from trading in these contracts, the Journal notes. Based on data from the CFTC, the number of bets made on a falling VIX declined significantly late in 2018, in concert with the stock market plunge. The number of net short positions fell from about 133,850 in September to roughly 16,000 in late December, the Journal says.

The ProShares Short VIX Short-Term Futures ETF (SVXY) is another device for playing the short-vol trade. It value sank by 28.4% during the fourth quarter of 2018, while the S&P 500 was down by less than half as much, 14.0%. In 2019, the reverse is true. While the S&P 500 gained 9.0% through the close on Feb. 6, 2019, the ETF was up by almost twice as much, 17.1%. The VIX itself is down 39.5% YTD 2019, after soaring by 110% during the final quarter of 2018.

As long term investments, ETFs and ETNs linked to the VIX are of questionable utility, as discussed in a previous Journal article. Their high cost structures essentially guarantee that they will lose virtually all their value over the long haul, regardless of the direction of the VIX. These products, as a result, only make economic sense for short-term speculation., which itself is highly risky.

Looking Ahead

While the stock market may be in a period of relative calm right now, there are plenty of risks that can create a spike in investor anxiety, and thus also in volatility. These include, among many others, slowing economic growth in China, the unresolved U.S.-China trade dispute, and rapidly decelerating corporate earnings growth. Should volatility soar, these short-vol bets are likely to produce massive losses once again.