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Tuesday, August 5, 2014

Short vix keeps me up at night


What keeps me up at night? Shorting $VIX.

Here's why:


Shorting volatility has been a stupidly winning trade for basically ever. We're talking 6-8 times the profit in the SPY over pretty nearly any timeframe you wish to mention.

I don't know exactly what shorting Vix means from a mechanical standpoint, or why it should outperform the underling equities. Maybe it's just an artefact of rolling over? Maybe rolling your short from one contract to the next automatically makes you a profit?

Or maybe Vix's typical market-open move is to gap up (I dunno if it is), thus making you money as it goes back down from the leveraging point through the day?

Or maybe, while the ETF is called a short VIX ETF, what it's really doing is shorting the time premium? In effect that'd mean collecting rent from people who are long the options, right?

I dunno what XIV (or HVI) does, and that keeps me up at night.

Because you can ask "Why would you buy SPY when you can buy XIV?" And when you ask that, it gets frickin' scary.

An efficient market is supposed to arb away all alpha, right?

So in an ideally efficient market, XIV should make the same money for me as SPY.

That it doesn't means either that

1. there's not enough people shorting volatility yet

2. there's an underlying extreme risk in shorting $VIX that a XIV buyer is being paid a premium for

3. maybe in the ideally efficient environment we'd have a much lower volatility premium

4. maybe XIV is mixing the volatility premium with the time premium, and it's the time premium that the market has wrong.

Or maybe something else; those are just ideas off the top of my head. I really have no clue beyond the faintest understanding of what $VIX and volatility are and what short ETFs do.

Now, maybe shorting $VIX works because the equity market uses a rational (I guess financial) discount rate, while volatility premium is an artefact of the human psychological discount rate, which is one hell of a lot higher. You're basically arbing between rationality and emotion. If that's all it is, then I'd expect that remains a winning trade for a long time.

But if that's not it, if there's something else, then it gets scary.

Because from the little I know, the market never had a significant arb mechanism between equity prices and volatility premium, and with the new synthetic ETFs it does.

If XIV performance were to decay to the point where it matched SPY performance, that might demand a massive change in option pricing, and god knows if the market (and the robots who populate it) would have any clue what they're supposed to do when that move started happening.

That frickin' scares me.

Oh well, back to stacking bullion and canned tuna I guess....


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