SocGen Quant Shows Why You Should Short Vol When Growth Goes Bad

(Bloomberg) -- Betting against market volatility in the grip of an economic slowdown looks like the road to ruin. But as global recession fears break out, here's a reminder that bullish trades in bearish markets can pay off handsomely.

Selling volatility across stocks, fixed income and currencies has consistently delivered positive returns when the economy goes south, according to Societe Generale SA quant Olivier Daviaud.

After backtesting options strategies during downtrends in the business cycle, he finds the most profitable wager is shorting price swings in credit, offering a 6.5 percent paper return on average.

The logic behind these stellar gains is received wisdom among derivatives traders but a mystery to the uninitiated. It's known as the volatility-risk premium, or the tendency of investors to demand higher compensation for future uncertainty compared with what actually comes to pass.

That's fueled the post-crisis boom in financial instruments linked to bets on price swings for real-money and fast traders alike -- one that keeps on defying talk of its demise.

“There's a reason why the short vol strategy has become so popular,” said Yannis Couletsis, director at volatility hedge fund Credence Capital Management Ltd. “It recovers quicker following market shocks, drawdowns are not more dramatic than other strategies, and for a targeted return -- say 6 percent -- it often proves the less risky way to achieve that.”

Recession Signs

Reams of evidence that traders over-pay for what's effectively insurance against future losses can make this strategy look too tempting to pass up even when weaker growth imperils corporate health and increases monetary uncertainty.

“When things are heading south, the probability of imminent disaster is much higher, but the risk premium is also significantly higher,” said Pravit Chintawongvanich, an equity derivatives strategist at Wells Fargo & Co.

Bears are on the look out for signs of an economic slump in developed economies, with more than three-quarters of U.S. corporate chief financial officers expecting one by the end of 2020. The OECD defines downturns and slowdowns as periods when its leading indicator is either above 100 and decreasing, or below 100 and falling. Currently, the signal is pointing to “easing growth momentum in most major economies,” according to the Paris-based body.

Speculative Shift

And so the short-vol complex goes on. Hedge funds following the strategy earned 4.2 percent in January, their best month in over a decade according to Eurekahedge data. The latest CFTC data -- delayed due to the U.S. government shutdown -- show speculators flipped short the Cboe's Volatility Index in January.

Options sellers expose themselves to the prospect of unlimited losses in tail scenarios, while the pain for buyers is limited to the premium paid. That keeps the difference between future expectations of volatility and what transpires at a persistent spread, all but guaranteeing shorts make money -- except when swings suddenly break out.

While crumbling sentiment typically sends both implied and realized volatility higher, once markets adjust to the new climate, historic volatility tends to drop while implied stays elevated, according to Daviaud.

“This allows vol premium strategies to recover from their drawdown, and then more,” he wrote, as part of a sweeping study into volatility as an asset class. The bank tested options selling in each of the asset classes in periods ranging from 13 to 16 years, according to the SocGen strategist.

Of course, the findings support the case for shorting volatility in theory -- investors in real life contend with trading costs and risk management.

The only investing style studied by SocGen that didn't generate a positive return overall is the greenback-Aussie dollar trade, as structured products linked to the pair tend to suppress the implied gauge.

To contact the reporter on this story: Yakob Peterseil in London at ypeterseil@bloomberg.net

To contact the editors responsible for this story: Samuel Potter at spotter33@bloomberg.net, Sid Verma

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