Avoiding the landmines of short vol

Product Review: VYLD

The world of short volatility is alluring.

We’ve spoken about it several times here before, with futures positions, condors, and other short options structures. It’s not just the mean reversion that is all but guaranteed, I think there’s a masochistic desire to short, to be a contrarian. Either that or the steady drip of returns in calm markets.

The catch with short volatility is that while it can be an “often” trade, it can’t be an “always” trade. It’s a question of both timing and sizing. Signals are needed to better identify the right time, and the magnitude of the trade has to take into account the convexity of the position.

In a competitive market, signals are getting harder. The classic indicator is something like contango/backwardation, where the term structure decides whether to put the trade on. During the calm of cantango markets it is perfect for collecting vol risk premium.

Unfortunately this bellwether has degraded. In our own study we saw the last 12-16 months being difficult, and Kris Sidial has confirmed similar results showing that 2024/2025 both had negative results for this signal. Whether this is due to overcrowding of the trade or a paradigm shift for vol markets it’s too early to tell.

Yet the desire to be short volatility remains unabated. To meet this demand, a number of different volatility ETNs have been listed over the years. XIV famously blew up during Volmageddon when the VIX made its largest one day move and tested the upper (lower?) bounds of a -100% move in a short product.

The fear index itself isn’t tradeable, so any packaged retail product needs to construct a series of swaps, futures, or other derivatives to mimic that behavior. It’s not always perfect - large moves are hard to capture, and daily rebalancing of percentage changes makes these non-intuitive for long term holders. (The roll decay and fees should already be enough to scare you away from a long term position here.)

So far most of the 1x, 2x, and -1x products have tracked the VIX the way other levered and inverse products do - percent for percent. This jibes with how most people in finance think about position sizing. If you’re using the Ultra Gold ETP, you want 2x the returns of gold for whatever hedging or speculative purpose.

With volatility, things could arguably be different. There’s not only the -100% problem, the price of the VIX itself is already denominated in percentage points.

Today in Portfolio Design, we’ll take a look at the newest volatility product to enter the market - VYLD - which is looking to shake up how we think about positioning for short volatility trades.