Until two days ago equity market volatility was just incredible low. Hence, recommendations to bet on rising volatility popped up everywhere. But before you do so let me warn you first. Making a profit from such an investment strategy requires is extremely hard, if not impossible. Over and over again, a long position in volatility will become an unprofitable strategy. Especially, when volatility is low!

**Hedging volatility risk**

From a theoretical point of view, investing in volatility makes sense. Please take a look at the graph below. It shows that the correlation between changes in the S&P 500 Index and the VIX Index is outright negative. When volatility spikes, stocks go down and vice versa. No surprise there. Basically, if you are long equities you are short volatility. Therefore, adding some volatility to your portfolio should come with the benefit of diversification.

However, putting this theory into practice has undesirable side effects. Investors holding equities, realize that they are short volatility,. Therefore, they are willing to pay a premium to hedge that short position in volatility. It’s exactly for this reason that the realized volatility is on average lower than the implied volatility (represented here by the VIX Index.) The graph below shows this ‘volatility risk premium’ over time. The black line, which represents realized volatility lies below the blue line, which represents implied volatility, most of the time.

**The volatility risk premium**

Since you can’t trade the VIX Index directly, you have to turn to the derivatives market, instead. And there you will be confronted with the volatility risk premium in an unpleasant way. Take the VIX futures market. The graph below shows the two possible slopes of the futures curve, backwardation and contango. In practice however, contango is, by far, the dominant shape of the VIX futures curve. Especially when volatility is low. (Mind you, the slope itself is irrelevant for the concept of the volatility risk premium.)

The ‘contango curve’ above indicates you can buy a 1-month volatility future at a price of 16, while the current VIX spot index is at 13. This implies a negative roll return of 19% (13/16-1). Theoretically, this negative roll return will be completely offset as the VIX spot price increases to 16 over that 1-month period. But, in practice this won’t happen. On average, the VIX Index won’t get to 16, but stay below that number, let’s say at 14. The difference between the two is the volatility risk premium. You simply have to pay up to hedge your volatility risk. The seller of the VIX future is the one that collects this premium. To make things worse: the volatility premium tends to be bigger when volatility is low! So, just when you think it’s a wise idea to invest in volatility, because the VIX Index is ‘attractively low’, you get hit hardest by the contango in the futures curve.

**Crystal ball**

The volatility risk premium demands that your timing skill is impeccable when you go long the VIX Index. For each month in which the VIX doesn’t go up, you lose the volatility risk premium. And that loss can very significant. A 5-10% premium (read loss), per month(!) is no exception. If you find that hard to believe, just take a good look at the graph below. It shows the returns of two ETFs: one that invests solely in long VIX futures and one that only invests in short VIX futures. That is a very convincing gap!

Since 2012, an investment of USD 100 in the ETF that goes long volatility almost completely evaporated, just USD 70 cents would remain, a loss of 99.3%. But an investment in the short volatility ETF would,even after yesterday, be worth just shy of USD 1000. A return of 900%! The difference: paying or receiving the volatility risk premium. If you still feel confident about taking a long position in the VIX Index, my guess would be that you own a crystal ball!

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