Return of the Short Volatility Trade in 2024 Amid Hedge Fund Activity

In a notable market development, the "short volatility trade" is staging a comeback in 2024, with hedge funds taking positions to capitalize on reduced market volatility, primarily through VIX futures. This strategy, infamous for its 2018 setback known as "Volmageddon," involves betting on a calmer market environment.

What is the Short Volatility Trade?

Reintroduced as a lucrative play in 2023, the short volatility trade involves betting against short-term futures linked to the Cboe Volatility Index (VIX), often referred to as Wall Street's "fear gauge." Traders utilize call or put options and directly engage in buying or shorting futures contracts tied to the VIX to profit from subdued market movements.

Success in 2023 and Market Conditions

The appeal of the short volatility trade in 2023 was fueled by the stability in the Cboe Volatility Index. The VIX, analyzing S&P 500-linked options, consistently traded below its long-term average, indicating an expectation of minimal market fluctuations. Analysts specializing in equity derivatives highlighted the profitability of this strategy in a market that neither significantly rises nor falls.

The success of the short volatility trade in 2023 was further underlined by the S&P 500's unusual calm, with no 2% movement in either direction for over six months, marking one of the calmest periods in the past 25 years.

Risks and Lessons from "Volmageddon" in 2018

While the short volatility trade proved effective in generating returns, it carries significant risks, especially for those using substantial leverage or neglecting proper hedging. The notorious "Volmageddon" in 2018 serves as a cautionary tale, as a sudden spike in the VIX caused a market shock, leading to a record decline in the Dow Jones Industrial Average.

The unexpected surge in the VIX, driven by rising Treasury yields and concerns over an overheating US economy, resulted in a widespread market meltdown. Short-volatility exchange-traded funds (ETFs) faced challenges covering their positions, leading to billions of dollars in investor losses and the suspension of trading in VIX-linked ETFs.

In conclusion, as the short volatility trade re-emerges, investors are reminded of the inherent risks, drawing lessons from past market shocks and emphasizing the need for prudent risk management strategies.