The podcast discusses the return and popularity of the short volatility trade, including the risks and poor habits associated with it. It explores how investors use this trade as a hedge and the increase in derivative income generating funds. The fascination with income-generating derivative strategies and the challenges faced by market makers in managing their positions in options are also discussed. The concept of being long or short volatility and the controversy surrounding zero-day options and retail trading are examined.
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Quick takeaways
Shorting volatility has become increasingly popular again, with a rise in volume of shorter-dated options and other derivative instruments.
The resurgence of the short volatility trade has led to concentration of risk and potential challenges for market makers and dealers.
Deep dives
Short volatility trade and its popularity
The popularity of shorting volatility has returned, despite the potential for one-off events and increased market uncertainty. Shorting volatility post the 2008 financial crisis became popular due to low interest rates and central banks suppressing volatility. However, shorting volatility has become increasingly popular again, with a rise in volume of shorter-dated options and other derivative instruments. This raises questions about why short volatility is back and its implications for the broader market.
The rise of shorter-dated options
The increase in popularity of shorter-dated options, including zero-day options, has contributed to the return of the short volatility trade. Investors and institutions have started favoring shorter-dated options rather than longer-term ones, attracted by lower premiums and reduced path dependency. However, this focus on shorter-dated options may overlook the potential for one-off events and market disruptions, highlighting the need to consider longer-term hedging strategies.
Impact on market participants and ecosystem
The resurgence of the short volatility trade has led to concentration of risk and potential challenges for market makers and dealers. With fewer market makers in the options market, the surge in options trading, especially in the S&P and VIX complexes, has created higher net short Vega notional and increased exposure for market makers. This can lead to cascading effects and potential market instability when volatility rises and end users open new positions or close their existing ones.
Challenges and risks of short volatility trading
Shorting volatility has experienced significant growth in recent years, but it comes with its own set of risks. While shorting vol can be profitable during periods of low volatility, it can also lead to significant losses during market downturns or unexpected events. Many long-term solutions-based defensive hedging strategies have underperformed, reinforcing the importance of tactics and risk management in short volatility trading. It is crucial for market participants to understand the dynamics of the options market and maintain a balanced approach to managing exposures.
There are plenty of one-off risks at the moment, but it seems like betting on pretty much nothing happening is more popular than ever. Investors are increasingly reaching for a wide variety of derivatives to bet against volatility. Those derivatives include one- and zero-day options which expire in 24 hours or less, and have become a hot button topic on Wall Street. So what's the impact of this explosion in options trading? Why is it happening at a time when the possibility of major disruptions seems more likely than ever (even if realized volatility remains low)? And what impact could it have on the wider market? In this episode, we speak with Kris Sidial, Co-CIO of Ambrus Group, about the return of the short vol trade.