The Booming Short-Volatility Bet That Lost 46% in a Single Month

A booming but opaque volatility trade beloved by hedge funds just erased two decades of performance in a single month.

Betting against price swings in the S&P 500 Index via an over-the-counter instrument known as a variance swap returned minus 46% in the month through March 20, according to Barclays Plc. While perennially popular, the trade has ballooned in recent years as banks unloaded their volatility exposure to hedge funds and other asset managers hungry for yield.

Exactly how much was riding on such wagers is not known, but the short-volatility complex overall is estimated at as much as $1.5 trillion.

A variance swap is a contract that allows for pure-play bets on the relationship between expected volatility and what actually comes to pass. One party pays a fixed amount over the life of the contract, while the other pays an amount based on actual movements in an underlying asset. Taking the short leg amounts to betting that prices stay calmer than the market expects.

It can be a supremely profitable trade in normal times, but it went badly wrong in last month’s historic turbulence. Daily moves in U.S. stocks were comparable to those last seen during the Great Depression.

The S&P 500 “had one of the worst expiration to expiration selloffs (-30.9%) in the past 30 years over the period of the February 2020 and March 2020 regular options expirations,” Barclays strategists led by Maneesh Deshpande wrote in a note this week.

Buyside Billions

That led to sharp losses, though hedged versions of the same strategy and options-based trades performed better, according to the bank.

The swaps are among numerous wrong-way bets on equity volatility that have caused turmoil for many hedge funds. Graham Capital lost about $500 million wagering on price swings, while Malachite Capital Management, a New York-based volatility trader that oversaw about $600 million, said it’s shuttering its funds in a March 17 statement.

Such bets “were huge and very popular and very profitable over the last three to four years because we haven’t had a major volatility event,” QVR’s Benn Eifert said in a March 30 podcast hosted by MRA’s Dean Curnutt. “Here you saw billions of dollars lost on the buyside very quickly on those positions.”

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