Once the piece I wrote yesterday went online (“Why Is Volatility So Low and What Should We Do Now?”), I received a number of questions on why now is the time to quit selling volatility and be careful. Couldn’t we have said the same thing a few months, or maybe a few years ago? The straight answer is that I don’t really know, but the risk vs reward of being short volatility now is immensely skewed in the wrong direction. The answer boils down to option arithmetic and participant behavior.

Let us illustrate this with some calculations of the purest form of volatility selling, the option straddle. A straddle sells a call option and a put option simultaneously at the same strike and for the same expiration. To be very concrete, let us assume that this is a one year straddle on the S&P 500. Please indulge me with some option “Greeks”, so that we can make the point.

When option implied volatility is at 30%, the price of this one year straddle is 23%. The “delta” or rate of change of the option price with respect to the underlying is close to zero, since the delta of the put and the call cancel out. However, and this will be important in a moment, the rate of change of the delta, or “gamma” is 2.5. In other words, the delta itself changes by 2.5% if the underlying asset, in this case the S&P 500, moves by 1% either way.

When option implied volatility falls to 20%, which is close to the long term average for the S&P 500, the price of the straddle falls from 23% to 15%, which is a 33% reduction of premium. In order to generate the same “yield” from option selling, the seller now has to sell 33% more straddles. Now note that the gamma at this lower volatility increases from 2.5 to 4. So for the same income, increasing the position size results in a total gamma of more than double than what it was for the 30% volatility case.

Now fast forward to today. When volatility is at 10%, the price of the straddle falls from 15% to 7.5%, a 50% reduction in price. So to get the same income as in the 20% volatility case, a doubling of the notional sale of straddles is needed. The gamma of the straddle at 10% volatility is 7.5, so with the doubled notional, the gamma of the equal yielding position is 15!

Compare this to where we started. While the yield earned is the same due to increasing the notional proportionately to the reduction in premiums, the gamma has increased six fold relative to the original starting point of 30% implied volatility! Put this in the back of your mind for a second, and we will come back to it.

Next, assume that when volatility was 30%, a few brave souls (as in the aftermath of the financial crisis when volatility hit 50% or higher with almost 40% premium for the straddle) started a strategy of selling volatility, which was a pretty decent risk-reward. By the time volatility got to 50%, most of the investors who had gotten burned selling options had thrown in the towel, leaving a new crop of traders with fresh capital, who had been waiting and who saw how exciting and easy income was from selling options.

Nothing brings in imitation like success, so by the time volatility got back down to its long term average of 20% after late 2010, most sophisticated investors are lured back in the trade of selling volatility. By this time there is likely a three year or longer track record of making excess returns from selling options from the early sellers. This naturally finds its way into the broader marketplace, and the financial industry obliges happily by creating products (e.g. XIV started in November of 2010 and SVXY in October 2011), that allow anyone to sell volatility by “buying” a security. Actually the XIV and SVXY sell volatility using the VIX futures, but the VIX futures themselves are the market’s forecast of implied volatility of options, so there is no fundamental difference between selling volatility through purchase of the XIV or by just selling straddles.

At this stage volatility selling is institutionalized and everyone is in the volatility selling game and can trade the inverse of volatility like a stock. Volatility selling now is religion – regardless of price, and this is where risks begin to build up.

What happens next is rather forecastable. Remember that gamma increase of six fold? Here is how it comes into play. The market fluctuates like it always does. At high implied volatility there are fewer sellers of volatility, and the need to “hedge” is less (since gamma is lower), the market is not really exposed to the behavior of the hedgers. In contrast, when volatility is very low, and the market fluctuates, the six fold increase in sensitivity to the movements of the underlying along with the now significantly larger number of participants (including some who sold volatility simply based on historical returns, without holding power and not really well versed in volatility dynamics) can easily trip the markets into a cascade. Once the hedgers begin to hedge, the outstanding amount of hedge instruments might not be able to accommodate everyone’s needs, at least not with the same liquidity that they had been expecting.

Ultimately the inability to hedge results in capitulation, which basically means buying back the short volatility positions from others, who have been waiting patiently, but at a much higher level of volatility. Time passes, and as memories fade, the cycle starts again. Advice to the wise – given the risks today be careful selling volatility today.

*Vineer Bhansali, Ph.D. is the Founder and Chief Investment Officer of LongTail Alpha, LLC, a California-registered investment adviser and a CFTC-registered CTA and CPO. Any opinions or views expressed by Dr. Bhansali are solely those of Dr. Bhansali and do not necessarily reflect the opinions or views of LongTail Alpha, LLC or any of its affiliates (collectively, “LongTail Alpha”), or any other associated persons of LongTail Alpha. You should not treat any opinion expressed by Dr. Bhansali as investment advice or as a recommendation to make an investment in any particular investment strategy or investment product. Dr. Bhansali’s opinions and commentaries are based upon information he considers credible, but which may not constitute research by LongTail Alpha. Dr. Bhansali does not warrant the completeness or accuracy of the information upon which his opinions or commentaries are based.*