Pimco Gets Impaled on a Volatility Spike

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.

About Craig Pirrong 228 Articles

Affiliation: University of Houston

Dr Pirrong is Professor of Finance, and Energy Markets Director for the Global Energy Management Institute at the Bauer College of Business of the University of Houston. He was previously Watson Family Professor of Commodity and Financial Risk Management at Oklahoma State University, and a faculty member at the University of Michigan, the University of Chicago, and Washington University.

Professor Pirrong's research focuses on the organization of financial exchanges, derivatives clearing, competition between exchanges, commodity markets, derivatives market manipulation, the relation between market fundamentals and commodity price dynamics, and the implications of this relation for the pricing of commodity derivatives. He has published 30 articles in professional publications, is the author of three books, and has consulted widely, primarily on commodity and market manipulation-related issues.

He holds a Ph.D. in business economics from the University of Chicago.

Visit: Streetwise Professor

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