Thou Shall Not Short the VIX

Thou Can Not Short the VIX

March 2020. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • The VIX has not remained at high levels for long in recent times, theoretically making a mean-reversion strategy attractive
  • However, there were periods historically where volatility stayed elevated for years
  • Furthermore, the VIX is not a tradeable index and related products should be viewed with caution

INTRODUCTION

Scratching the surface of most people’s knowledge often does not reveal depth, but a lack thereof. When the former US Democratic candidates Tom Steyer and Amy Klobuchar were asked to name Mexico’s president, who is one the key counterparties for any US president, both failed. Surveying US citizens on where well-known tourist destinations like Italy or long-standing political foes like Iran are located on a world map results in rather awkward outcomes.

Similarly, most investors are familiar with the VIX as it is frequently quoted in financial media, but few make the effort to understand how it is calculated. For the majority of speculators, it simply represents the fear index, which is not a particularly accurate nor useful interpretation.

Given that the VIX has lately been trading at levels similar to those during the global financial crisis in 2008 to 2009, investors likely perceive the market sentiment to be at peak fear level. Some investors have noted that the VIX has mean-reverted quickly over time and are contemplating to short the index.

In this research note, we will investigate shorting the VIX from a theoretical and practical perspective.

IMPLIED VERSUS REALIZED VOLATILITY

The VIX measures the implied volatility of 30-day options on the S&P 500, although the actual calculation is quite complex. Implied volatility tends to be higher than realized volatility, which is called the variance risk and can be explained by investors paying a premium for options to hedge their portfolios. However, regardless of these well-known differences, the trends in both are almost identical (read Minimum Variance Versus Low Volatility).

In March 2020, the VIX reached an all-time high and breached the previous high from the global financial crisis. It seems that historically these peaks