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VIX: Has Vol-of-Vol Stopped Working?

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One of the phenomena we have focused on a lot in our CBOE Volatility Index (VIX) trading over the last few years is the volatility of volatility. The idea we're chasing is that the likely realized vol (standard deviation of log returns) of a vol product will be lower than the volatility implied by options prices. In terms of liquidity and market size, VIX is still the only game in town, although options on gold (GVZ), oil (OVX) and other symbols may yet find an audience.

In the past, it has been profitable to be short vol-of-vol at a short-time horizon. Consider the performance of a strategy that sells VIX option straddles in the first two months and rebalances option exposure daily to maintain a constant one-month horizon. The strategy also hedges any delta exposure daily using VIX futures. The strategy is effectively short the (realized) volatility of (implied) volatility, since the principal risk is from periods when VIX futures move sharply in either direction.

The performance of this strategy was excellent throughout the second half of 2012, with almost no drawdowns to speak of and a smooth equity curve (fig. 1). However, short VIX straddles have seen a bout of weakness in the last several months. Those drawdowns coincided with the large spikes higher in VIX related to the U.S. "fiscal cliff" around the turn of the year and the Italian election in late February. Those two rallies in implied vol were faster than the norm, and given the event-driven nature of the strategy drawdowns, I think it would be too hasty to extrapolate forward from this quarter's weakness. We will keep monitoring the performance of this and related strategies; my suspicion is that short vol-of-vol strategies will return to form this year.

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