An Early Look Back at 2018

2018 hasn't been a good year for volatility funds.

In February there was a feedback driven catastrophe in the implied volatility space. The details are less important than the result. A lot of volatility funds lost more than 30% in the month and one of the largest funds lost over 80% in a day.

The last few months have also been tricky. Equity markets have been more volatile than expected, but the bigger problems have been in the commodity space. In particular, crude oil and natural gas have been, to quote a very experienced trader, "****** unbelievably ****** insane! Like ****! Seriously dude. ****!". And you may have seen a sad youtube video where a hedge fund manager tearfully apologizes to his clients for losing all of their money due to the "rogue wave" in the natural gas market.

I'm not dancing on anyone's grave. I hate to see a business fail and I hate to see investors lose money. But there are also some important lessons here.

  • February emphasized that implied volatility risk needs to be considered. Many volatility funds just look at realized volatility.

  • November's commodity issues showed that risk management is crucial. No move, whether it is a rogue wave or not, should be able to blow up a fund.

  • The intrinsic edge from selling options is hard to capture.

But most importantly, investors need to realize that most volatility funds are selling a lie. The lie is that they can sell options and then somehow manage the risk when things go wrong. This is the wrong way around. Once you are in a position, it doesn't matter how smart you are. The time when being smart helps is before the trade is entered. Volatility is somewhat predictable, but that won't help unless you make the effort to actually predict it.

There absolutely is a variance premium. Implied volatility is on average over-priced. But "on average" is very different to "always". And most volatility funds do nothing more than sell and hope. That isn't worth paying 2/20 for. It isn't even worth paying 0/0 for. If you are investing in the volatility space, ask your manager if they forecast volatility, how they forecast volatility, if they view implied volatility as a separate risk and if they are ever un-hedged.

I think you know the answers we would give,

Euan SinclairComment