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Ever heard of the ‘Vola-Saurus Rex’? Well, up until a few days ago, Wall Street loved that beast.

It was big, slow, and bloated, lounging around like it owned the place. It symbolized overweight bets on low volatility, expecting tranquility while it grew more fat and more complacent. But then, out of nowhere, it got taken down. Didn’t even see it coming.

I’m sure you saw markets around the world dive on Monday. A perfect storm of fears— a slowing U.S. economy, rising Japanese rates, and crumbling tech stocks —helped fuel panic and send turbulence through the roof.

One second Vola-Saurus Rex was there, the next - poof - almost wiped out.
The fall of that beast is a reminder that when things seem calm, that’s when you should start worrying.

You get too comfortable, thinking nothing can touch you, and bam - chaos is right around the corner. Like I shared with you last December, calm times sow the seeds of chaos (read here).

So, was this mess inevitable? I believed so. Still, even the smartest of money managers got caught with their pants down.

Now, as we reflect on the Vola-Saurus Rex’s recent demise, it’s clear that complacency is no match for the curveballs a complex world throws at you

Let’s dive into one of Wall Street’s favorite bets that just spectacularly blew up and see what kind of mess it left behind.

Bloody Monday: When Market Volatility Exploded

Just like the meteor that wiped out the dinosaurs, Monday’s market meltdown obliterated derivative trades betting on calm times, setting off a potential chain reaction that fueled global market chaos.

This financial quake was marked by the Cboe Volatility Index — Wall Street’s 'fear gauge' — skyrocketing by a record amount¹, as the S&P 500 plunged by 4.3%.

The bet that markets would stay calm has cost retail traders, hedge funds, and pension funds billions after a global stock selloff, underscoring the dangers of this popular “short volatility” strategy.

Simply put, markets panicked. And panicked hard, sending the VIX (the Wall Street derivative of fear) through the roof – to levels not seen since 2020 and 2008.

The Risks of Shorting Volatility

Now, you may be wondering, “How does one short volatility? Why would they do that?” Here are the basics of shorting volatility without requiring an economics or finance degree.

Shorting Volatility:

• Betting on Calm: Wagering that markets will stay calm.
• Profit in Stability: Makes money when there’s no chaos.

Risks:

• Unlimited Losses: Potential for severe losses if market volatility spikes unexpectedly.
• Market Shocks: Sudden events, like geopolitical crises, can cause huge spikes in volatility, leading to massive losses (e.g., "Volmageddon²" in 2018).
• Leverage Risk: Leverage can magnify both gains and losses, making volatile markets especially risky as investors rush to unwind positions.

As you may have noticed, the downside (risk) significantly outweighs the potential gain, making shorting volatility an “asymmetric” trade (high risk, low reward).

Think of it this way: imagine you're running a quiet library. You bet your friends (essentially selling them insurance) $10 that it will stay quiet all day. If it does, you keep the $10, and if it doesn’t – you pay them.

So in essence, you are:

• Betting that the library will stay quiet.
• Profiting if it stays quiet and peaceful.

But there are big risks – such as:

• If a group of noisy kids suddenly enter, you then have to pay your friends $50 each.
• The unexpected noise represents a sudden spike in market volatility, causing you significant losses in a quick amount of time

So, shorting volatility is like betting the library will stay quiet and you profit if it does (which 9/10 times it will). But if it does get noisy, you can lose a lot more than you bet.

Now keeping this in mind, that’s exactly what we’ve seen over the last few years on Wall Street regarding these short volatility bets...

Wall Street's Massive Tranquility Bet Backfires: Chaos Crushes Short-Volatility Traders

So how did this crush Wall Street traders?

Because “short volatility” bets became one of the most overcrowded trades lately as investors believed markets would remain docile and the Fed would achieve its fabled “soft landing.”

Headlines like “The Short-Vol Trade Is Back: Why Some Investors Think It’s Driving Tranquility in Markets”³ and “Why the Short Volatility Trade Is Back and Bigger Than Ever”4 appeared throughout the first half of 2024.

Investors poured money into strategies that depended on market stability, primarily through ETFs that sell options to juice up returns.

For instance, assets in these products have nearly quadrupled in two years to $64 billion, according to Global X ETFs⁴. In contrast, 2018's short-volatility funds had only $2.1 billion before crashing.

This is an absurd amount of money that piled into short-volatility bets – especially in a contentious Presidential Election year and powder keg events globally (such as Houthis in the Red Sea, the Israel and Palestine crisis, the Russia-Ukraine war, the Chinese property sector collapse, and much more).

And as mentioned above, shorting volatility is like betting that a quiet library will stay peaceful. You collect small fees from friends upfront, similar to collecting insurance premiums. As long as the library remains quiet, you earn steady, limited profits.

But if unexpected noise erupts, like a group of noisy kids entering, you face significant losses.

And that’s exactly what happened last week.

After years of “sophisticated” traders reaping huge returns from these short-volatility bets, they quickly felt the pain. A big two-day spike in the Cboe Volatility Index caused huge losses for anyone betting on calm markets.

For example, the ProShares Short VIX Short-Term Futures ETF (SVXY), which tracks this strategy, lost all the gains it had made since late 2023⁵. Thus wiping out nearly a years worth of gains within a handful of days.

Meanwhile, investors in the top 10 short-volatility ETFs saw $4.1 billion in returns wiped out from earlier highs, according to Reuters, LSEG, and Morningstar data.

Then there’s the VVIX Index - often referred to as the "VIX of VIX" and measures the expected volatility of the VIX Index itself - skyrocketing to its highest level since peak-COVID years, marking one of the largest increases ever (in percentage terms).

Ah, the VVIX - because betting on the VIX wasn’t quite meta enough…

It’s like someone looked at the VIX, which is already a bet on how wild the market might get, and thought, “You know what this needs? Another layer to bet on.”

So now we have the VVIX, which is basically a bet on how volatile the bets on volatility might be (aka the VVIX is essentially calculated from options on the VIX).

• It’s the financial equivalent of betting on how shaky the weatherman looks while he's trying to predict a storm.

And on and on we go, adding ever more layers to this volatility inception, until we’re so far down the rabbit hole that even the Cheshire Cat is lost.

Worse still, there’s some evidence that publicly available data on ETF performance⁶ failed to fully capture the losses suffered by pension and hedge funds trading privately through banks as the short-volatility bets unwound. So, we don’t even know who suffered or by what amount.

Talk about unsettling…

Lessons Learned from the Vola-Saurus Rex's Demise

The most ironic part is that anyone caught offside in this trade and looking to reduce their short-volatility exposure will likely need to buy volatility (to hedge), thus adding to the chaos and increasing the VIX. Making matters worse, these institutions may have to liquidate other assets to cover the losses, potentially causing a broader market downturn.

This is why I call derivatives Weapons of Mass Financial Destruction – getting caught offside can wreak havoc globally.

So, the next time you notice the markets getting frothy and investors expecting tranquility, remember the Vola-Saurus Rex.

Things may be calm now, but an asteroid could be lurking right around the corner, ready to crash the party – just as we’ve seen over the last week.

The question remains: Will there be any contagion (like an ice age) from this extinction-like event triggered by short volatility bets unwinding?

Or was it merely a brief disturbance, soon forgotten? Time will tell.

But as always, this is just some food for thought.

Sources:

1. Global Stock Market Selloff: Record VIX Spike Rocks Traders All-In On Calm - Bloomberg
2. The Short-Vol Trade Is Back: Why Some Investors Think It’s Driving Tranquility in Markets - WSJ
3. The Short Volatility Trade Is Back and Bigger Than Ever. Here's Why: - Bloomberg
4. The Short-Volatility Trade Roars Back on Wall Street - Bloomberg
5. The 'short volatility' trade has finally blown up. Why investors probably aren't waiting to pile back in. | Morningstar
6. Traders Lose Billions on Big Volatility Short After Stocks Rout (usnews.com)

Disclosures:

This communication is general in nature and provided for educational and informational purposes only. It should not be considered or relied upon as legal, tax or investment advice or an investment recommendation, or as a substitute for legal or tax counsel. Any investment products or services named herein are for illustrative purposes only and should not be considered an offer to buy or sell, or an investment recommendation for, any specific security, strategy or investment product or service. Always consult a qualified professional or your own independent financial professional for personalized advice or investment recommendations tailored to your specific goals, individual situation, and risk tolerance. All examples are hypothetical and are for illustrative purposes only.

Information contained in the materials included is believed to be from reliable sources, but no representations or guarantees are made as to the accuracy or completeness of information. This document is provided for information purposes only and should not be considered as investment advice.

Index Definitions

S&P 500 Index The S&P 500, or the Standard & Poor’s 500, is a stock market index based on the market capitalizations of 500 large companies having common stock listed on the NYSE or NASDAQ. The S&P 500 Index components and their weightings are determined by S&P Dow Jones Indices. It differs from other U.S. stock market indices, such as the Dow Jones Industrial Average or the Nasdaq Composite index, because of its diverse constituency and weighting methodology. It is one of the most commonly followed equity indices, and many consider it one of the best representations of the U.S. stock market, and a bellwether for the U.S. economy.

Cboe Volatility Index (VIX Index)- The VIX Index is a calculation designed to produce a measure of constant, 30-day expected volatility of the U.S. stock market, derived from real-time, mid-quote prices of S&P 500^® Index (SPX^℠) call and put options. On a global basis, it is one of the most recognized measures of volatility – widely reported by financial media and closely followed by a variety of market participants as a daily market indicator.

Cboe VVIX Index (the VVIX) - represents a volatility of volatility in the sense that it measures the expected volatility of the 30-day forward price of VIX^®. This forward price is the price of a hypothetical VIX futures contract that expires in 30 days. The VVIX is not the same as the expected volatility of the VIX, but the two are close because nearby VIX futures track the VIX.

Investors cannot invest directly in an index or benchmark.

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