Everybody's Doing it: Short Volatility Strategies and Shadow Financial Insurers

Abstract

The extraordinary growth of short volatility strategies creates risks that may trigger the next serious market crash. A low yield, low volatility environment has drawn various market participants into essentially similar short volatility-contingent strategies with a common non-linear risk factor. We discuss these strategies, their commonalities, and the generally unrecognized risks that they would pose if everyone unwinds simultaneously. Volatility selling investors essentially provide “shadow financial insurance.” Market participants and regulators would benefit from preparing for large, self-reinforcing technical unwinds that may occur when central banks change policy or when macro or political events affect investor confidence. We also discuss potential mechanisms that might provide stabilization against catastrophic financial outcomes.

Keywords: volatility strategies, options, market crashes, short VIX carry trade, volatility risk premium, risk-parity fund, risk premium harvesters, target volatility funds

JEL Classification: G01, G32, G11, G13, G23