Financial Literacy

How to Short Volatility: A Strategy Poised for a Comeback

Traders who short volatility have been quiet lately. But as the markets reach new all-time highs, they’ve stirred awake many a slumbering bear looking to make a bullish play and start shorting volatility again. After all, there’s money to be made… even during even brief spells of market tranquility.

Man relaxing in front of tickers because he is short on volatility

One of the easiest ways to benefit from ups and downs in the market is by investing in the Barclays iPath Series B S&P 500 VIX Short-Term Futures ETN (NYSE: VXX). This exchange-traded note tracks an index with exposure to futures contracts on the CBOE Volatility Index (VIX).

Just like the SPDR S&P 500 ETF Trust (NYSE: SPY) is designed to track the S&P 500 stock market index, the VXX is designed to track the CBOE Volatility Index (VIX). When the S&P 500 goes up, so too should SPY. And when the VIX goes up, the VXX should as well.

But since its spike in in early 2020, the VXX hasn’t seen much upside. The markets have been relatively calm. And this has triggered bearish long-term bets on the VXX. Even when the markets aren’t whipsawing, there’s still plenty of money to be made. This is exactly when it makes the most sense to short volatility.

Our Current “Calm” Explained

The Federal Reserve has pledged to support an economic recovery the best way it knows how: by keeping interest rates near zero. In turn, safer assets like government bonds are yielding all-time lows. This has pushed some investors into “safe haven” assets like gold. And rightly so, as gold flirts with an all-time-high valuation.

But there’s more than one way to turn a profit. Especially as the stock market has continued its steady upward march. That steadiness is why investors are thinking long and hard about making a play to short volatility. There are several ways to go about this. But here are some of the most common.

A Simple Play to Short Volatility

Let’s start with the basics. Short selling is borrowing shares of a stock and selling them immediately at the current market price. Then, down the road, you’ll need to buy back and return the same number of shares you borrowed. So you’ll profit when share price decreases. In order to short sell, first you’re going to need to set up a margin account. If that’s already established, the rest is fairly simple.

Let’s say the VXX is selling for $20 a share. You short sell 100 shares and fill your pockets with $2,000. But eventually, you’re going to have to return those shares to the brokerage you borrowed them from. If volatility remains low and the value of the VXX drops to $10 a share, you’re in luck. You simply buy back the shares at a cheaper price and return them to the brokerage. Here’s what that look like:

+$2,000 from the initial sale
-$1,000 to buy back the shares
__________________________________
$1,000 in profits, minus brokerage fees and interest

With no out-of-pocket money, this is a simple and straightforward way to short volatility… if the markets remain calm and composed.

Let’s say the markets decide that the Fed isn’t doing enough to stimulate the economy. Volatility starts to go up. Typically, volatility puts downward pressure on stocks. But the VXX is different. As the markets grow increasingly erratic, the value of the VXX climbs upward. And if you short sell the VXX at $20 a share, but it climbs to $40 a share, I’ve got bad news for you. You’re now in the hole for twice your initial investment. So making a play to short volatility is far from a sure thing.

There Is Another “Option”

Another popular way to take advantage of volatility is employing the short-volatility trade. This is where investors sell options to bet against price swings of the underlying security. Before we get too far into the weeds on this one, it’s important to know that there are seven key factors that determine the price of an option contract.

  • Current price of the underlying security
  • Dividend yield of the underlying security
  • Whether it is a call or put option
  • Expiration date of the contract
  • Risk-free interest rate
  • Strike price
  • Volatility

Out of these seven factors, only one is largely unknown: volatility. Now, it is easy to assess historical volatility. But implied volatility is more like a crystal ball. This data point suggests whether the underlying security is expected to remain consistent. And it’s far more relevant to an option contract’s pricing because it is forward-looking.

Here’s another way shorting volatility can be lucrative. Let’s say you see an option contract with an exceptionally high level of implied volatility… even though historically, volatility has been low.

If the implied volatility is high, you can bet that contract will sell for a premium. You decide to sell a few call option contracts that were borrowed from your brokerage. This can be done with your own money or with margin.

If your analysis proves fruitful and the underlying security doesn’t change much as the expiration date nears, the price of that contract will drop drastically. And you in turn can buy back the borrowed contracts at a huge discount or even let them expire worthless… fulfilling your obligation and pocketing the difference between the sell and buy price.

The Bottom Line on Shorting Volatility

Not all investment strategies are created equal. And short selling comes with a good deal of risk. This is just one of many ways to take advantage of the markets when they remain calm. But naturally, it’s unclear how long – and to what extent – calm will remain.

That’s why it’s as important as ever to diversify your investment strategy. Luckily, there’s a new investment opportunity around every corner. And if you’re looking for a new one, be sure to sign up for the free Trade of the Day e-letter. It’s the simplest way to keep a step ahead of the markets, gaining valuable insight into what will be moving them tomorrow.


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