PUTS IN PLACE

How a volatility investor made 6,000% while everyone else lost $2 billion

Last week, traders in a popular money-making activity, commonly called “the short vol trade,” had a rude awakening. The XIV—the most popular product to bet on US stocks volatility staying low—lost about 95% of its value, worth around $2 billion, in 15 minutes. It will now be shut down (paywall) by Credit Suisse, leaving investors with big losses.

But not everyone lost money when volatility returned with a vengeance.

A handful of professional investors—mostly small, sophisticated hedge funds—knew that if they wanted to trade volatility, they needed to look for protection from a violent storm of volatility as a kind of disaster insurance. These investors purchased put options that would provide them with protection if their short position went the wrong direction. The mechanism of the trade is in two parts. First, the investors would hold SVXY (an alternative to XIV), which goes up in value as long as volatility stays low and goes down in value if volatility goes up.

Second, the investors would offset the gains in SVXY by purchasing put options that would allow them to sell SVXY at a specified price. The insurance is that if volatility spiked and the value of SVXY went down the investors could sell shares at a higher price, hopefully at a profit.

Interestingly, these put options appeared to be extremely cheap. It was one of those times when human psychology was a factor in the price of financial products. Because markets had been so calm for so long, it was almost as if investors had started to believe that stability was the new normal. In a kind of collective confirmation bias, a belief formed that disasters were no longer possible and insurance was no longer needed, so the price of buying it became unusually cheap.

Houndstooth Capital Management in Austin, Texas noticed this.

Houndstooth was comfortable playing the short vol game but with the insurance protection of a cheap option. The put option, in this case, is a small but consistent “premium” against a volatility event that ticks along in the background. For a long time, this investment lost all its worth. Like any insurance, premiums feel like a drag.

Until the day the insurance policy gets called on. For Houndstooth, each “premium” payment (options contract) cost around 87 cents. On Feb. 5, they were sold for more than $55.

Explaining his reasoning to the Austin Business Journal (paywall), Houndstooth principal Lincoln Edwards (no relation to us) said:

Credit Suisse said they expect the long-term expected value of the product will go to zero. It’s right there in black and white. But it’s an arcane product, so it’s not well understood. Massive amounts of retail, non-professional investors bought into it without fully understanding the risk… You know it’s going to crash, but you don’t know when. The difference with us is, we got on the plane with a parachute.

Investors in short volatility products had been warned of the risks in the products’ initial prospectus as well as multiple other alerts. The risk of a rapid unwinding was widely known in the trading community, including, that theoretically, the index could go to zero on a single day. This week, those investors who either didn’t know how to protect their volatility assets, couldn’t value the insurance offered by a put option or simply didn’t think it could happen to them are likely wondering how they can do it differently next time.

“We bought our own insurance on the equivalent of a meteor hitting a house,” as Edwards put it.


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