Streetwise Professor

December 22, 2014

Pimco Gets Impaled on a Volatility Spike

Filed under: Derivatives — The Professor @ 9:41 pm

This is crazy to me: selling massive quantities of volatility when volatility is at very low levels.

Frustrated with buying volatility protection for years with no big payout, investors in 2014 decided to sell volatility protection themselves. Also known as shorting “vol”, the strategy typically entails selling options — a type of derivative that pays out if a particular asset moves by more than a pre-agreed amount.

“Those investors who had been looking to hedge their portfolios in the past, now looking for yield, switched their hedges for speculative short positions,” says Mr Verastegui. “They decided to be on the other side of the trade, and moved from being long to being short vol.”

Bill Gross, the founder and former chief investment officer of Pimco, became the prime exemplar for the trade when he announced at a prominent conference that his firm was betting against sharp market moves.

“We sell insurance, basically, against price movements,” he told Bloomberg News.

While selling volatility was, according to Mr Gross, “part and parcel” of a Pimco investment strategy that rested on sluggish US growth and low interest rates, it nevertheless raised eyebrows among his peers and competitors.

I’ll say. No doubt not only were eyebrows raised in Pimco, but much hair was torn out as well. No doubt this hastened Gross’s departure.

Look at the graph in the article and you can see the risks. Volatility frequently spikes. You sell vol at low levels-and the levels were historically low in the spring and summer-and you have a big risk of getting hammered when volatility spikes. And note that when volatility is at low levels, it doesn’t tend to spike down. It only spikes down after it has spiked up.

Indeed, the spikes in part reflect a positive feedback mechanism. When volatility starts to rise sharply, a lot of the shorts start to feel the pain and liquidate their positions. Due to the relatively limited liquidity in options markets, especially in stressed market conditions, these liquidations push up implied volatilies further, inflicting even greater losses on the shorts.

Shorting options is a widow maker trade. And wouldn’t you know, that many of the financial disasters in history involve shorting options (sometimes embedded in securities, as was the case with Orange County in the early-90s). Usually this is done to reach for yield. Sometimes it is done by those desperate for cash who sell premium to raise it: Nick Leeson and Hamanaka are examples.

Buffet sells long term volatility. That makes some sense. But selling large quantities of short term vol in a low volatility environment is like picking up nickels-hell, pennies-in front of a steamroller. And it looks like Bill Gross got flattened. Or more accurately, Pimco investors got flattened. Bill Gross, of course, made out like a bandit: he was paid $290 million in 2013.


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  1. Unfortunately, you espouse a commonly held view which is otherwise known as a myth. It all depends on how you manage the product. If you delta hedge vol product, selling options (otherwise known as ‘short gamma’ position) makes money so long as realized vol is below implied. There are quite a lot of inputs into the mark-to-market of a vol position, but selling vol when implied is low may make perfect sense if the expectation is that realized will be yet lower. This has been a winning trade in rates for some time as the CBs have drained any semblance of volatility from the fixed income markets throughout the QE-fest.

    One question: Short vol positions–how does the FT say people “know” about PIMCO’s position? There may be some debate on this one. Moreover, how can you be so sure it is short equity vol (where the action has taken place) rather than fixed income vol (PIMCO traditionally being a fixed income shop)?

    Comment by NickNickster — December 22, 2014 @ 10:44 pm

  2. @Nick-Uhm, I know that. That’s why I mentioned vol spiking, meaning that realized vol is above implied. Yes, if it’s low it can be lower, but the risks of volatility moves are asymmetric. Re equities vs. bonds etc. All vols moved sharply higher about the same time. Re delta hedging. Well, being short gamma your hedging errors (and you are never perfectly neutral delta) all go against you, and they can be big in a volatile market. Not to mention the effect that a big trader or traders hedge adjustments can have on prices and volatility. Believe me. I’ve seen the movie. I know how it goes.

    The ProfessorComment by The Professor — December 22, 2014 @ 11:56 pm

  3. There is nothing “eyebrows raising” in being short vol when vol is low. If that’s part of systematic process than managing risk properly would help avoid large losses. In addition, delta hedged options are far from being pure vol play with known downsides as The Professor mentioned.

    There is too little info on positioning and type of instrument used to play vol in order to draw any meaningful conclusions. Vol is the asset class with it’s own properties that one should know well before deploying gameplan.

    Comment by A.V. — December 23, 2014 @ 12:33 pm

  4. Worth considering that Vol is multi-dimensional, and is thus tradable outside of spot implied.

    Despite the persistent decline and suppression of spot (which, as you know, tracks realised) the vol surface itself is historically steep, providing an attractive source of premia for those able to expose themselves to the back end of the term structure.

    As Christopher Cole would suggest, since 2009 we have seen a significant bull market in fear…..Mr Buffett is especially savvy for having recognised (and indeed capitalised) on this.

    Comment by AJ — December 30, 2014 @ 5:38 am

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