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

23 Pages Posted: 17 Nov 2017 Last revised: 21 Feb 2018

Vineer Bhansali

LongTail Alpha, LLC

Lawrence Harris

University of Southern California - Marshall School of Business - Finance and Business Economics Department; Institute for Quantitative Research in Finance (the Q-Group); Interactive Brokers, Inc. (IBKR); University of Pennsylvania - Financial Economists Roundtable

Date Written: February 16, 2018

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

Suggested Citation

Bhansali, Vineer and Harris, Lawrence, Everybody's Doing it: Short Volatility Strategies and Shadow Financial Insurers (February 16, 2018). Forthcoming, Financial Analysts Journal, Vol. 74, No. 2, 2018. Available at SSRN: https://ssrn.com/abstract=3071457 or http://dx.doi.org/10.2139/ssrn.3071457

Vineer Bhansali

LongTail Alpha, LLC ( email )

500 Newport Center Drive
Suite 820
Newport Beach, CA 92660
United States

Lawrence Harris (Contact Author)

University of Southern California - Marshall School of Business - Finance and Business Economics Department ( email )

Marshall School of Business
Los Angeles, CA 90089
United States
213-740-6496 (Phone)
213-740-6650 (Fax)

Institute for Quantitative Research in Finance (the Q-Group) ( email )

Q Group
P.O. Box 1540
Valley Stream, NY 11582
United States

Interactive Brokers, Inc. (IBKR) ( email )

209 South LaSalle Street
10th Floor
Chicago, IL 60604
United States

University of Pennsylvania - Financial Economists Roundtable ( email )

Philadelphia, PA
United States

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