The truth about Short VIX Strategies

Is going Short VIX really dangerous?

The recent market turmoil where some Short VIX Leverage ETNs went belly up raise concerns among investors about the legitimacy of short VIX strategies. What happens to these leveraged ETN? How did some of them lose all the profit made over the last several years in just one day?

Clifford Asness from AQR in a tweet made the following comment:

“The vol fund story is subtler than what we hear. It is not shocking that funds that explicitly bet on calm by selling tail insurance gets creamed, even wiped out, in a big sell-off. It is shocking, at least to me, how small the event that killed them was. This was not 10/19/87.”

I completely agree with his view on the nonsense of these short-volatility strategies. However, if we dig more into the topic, we can say that “it’s all about leverage”, not about the instrument! Greed is the sin that led some investors to bet on calm and to sell insurance against potential market drawdowns with leverage that exceeds common sense.

Shorting VIX futures contracts can be profitable as long as it is done with sophisticated risk-controlled technologies, tight maximum loss parameters and no leverage. As illustrated in the graph below, a strategy that consists in systematically rolling 2 short futures contracts (front month – UX1 and a maximum trading loss of 4 points of VIX) for each 100 000$ invested would have generated a return of 17% on an annualized basis from Dec 31, 2006 to Feb 9, 2017. However, this return would have been achieved with a volatility of 28% and a maximum drawdown of 45%. This is not a strategy suited for everyone. However, this is not a strategy that would lead anyone to the verge of bankruptcy. Recall that the maximum drawdown for the S&P 500 index for the same periods is close to 50%.

It’s all about leverage!

Now let’s look at the returns over the same period with a ratio of 10 futures contracts for each 100 000$ invested (2 times leverage instead of 0.4). The strategy almost went belly up in early 2009 (I doubt anyone would have kept investing in it after such a disaster) but for the sake of this exercise we show the results afterwards. Like these Short VIX ETNs, the strategy lost everything in a single day on February 9, 2018. The fact that this strategy was so crowded may explain why it took so little in terms of market drawdown in the S&P 500 to destroy these Leveraged Short VIX ETNs.

Use of sophisticated Risk Management Technologies

Let's look at the return of a short VIX strategy, if we would have used a ratio of 2 contracts per 100 000$ with a tight stop loss and our proprietary Volatility Regime Indicator The strategy would have closed all futures contract positions during regimes of Bad Volatility. During these periods, we would have been invested in short term fixed income securities only.

The potential risk return would have been interesting (please note that this is a back test): 15% (annualized) with a volatility of 13% and a maximum drawdown of 16%. Not bad at all. 

By using sophisticated risk technologies and strict maximum loss trading rules, shorting VIX is not as silly as we might think. What is unreasonable is taking excessive leverage. As I like to say: #itsAllAboutLeverage. 

At OpenMind Capital we ran a live test on a Short Volatility Strategy. We managed a short VIX strategy with a ratio of 1 contract per 100 000$ invested for several months in 2015-16. We put an end to the test as we found it did not fit with what we do in our alternative strategies.

In a capitalist market, selling insurance premiums should be a profitable exercise. Like any traditional insurance company, selling insurance against market turmoil should be done with a level of leverage that can pass any risk management stress test.

In a perfect world, I would have sold all my Bitcoins at 19,000 last December and invest the money in a deep out-of-money call option on the VIX. Too bad for me…I was not greedy!