Caught in the crosshairs of the "big turmoil", suffered heavy losses from "short volatility" trading

The trading strategy of "shorting volatility" was once considered a "sure win" deal, but suffered huge losses in the recent market sell-off.

The popular "covered call options" ETF "bled rivers". Morgan Stanley's Equity Premium Income Fund (JEPI) has a year-to-date return of 4.9%, down 43% from its peak in early August, compared to the total return of 9.9% for the S&P 500 index, which fell 40% from its peak.

The "covered call options" strategy involves buying a basket of stocks while selling income derivatives related to the underlying assets. In recent years, the popularity of "covered call options" ETFs has soared, with assets under management growing from around $18 billion in early 2022 to about $80 billion in July, according to Morningstar data.

However, fears of a U.S. economic recession intensified, and the sudden rate hike by the Bank of Japan triggered a severe market stampede, causing a sharp increase in market volatility.

On Monday, the CBOE Volatility Index (known as Wall Street's "fear index" VIX) briefly surpassed 65, with an intraday increase of nearly 200%, marking the largest single-day volatility in the index's more than 30-year history.

At the same time, the CBOE S&P 500 Buywrite Index, which serves as a benchmark for the "covered call options strategy," fell 2.8% on Monday, slightly better than the 3% drop in the S&P 500 index. Although the S&P 500 has still risen by 9% year-to-date, the Buywrite's increase is less than 4%.

If you invested $100 in Global X's $800 million Nasdaq 100 "covered call options" ETF at the beginning of 2024, it would be worth $101.45 by Wednesday's close, while the investment in the underlying index would be $106.68. Since early August, the year-to-date return of Global X funds has dropped by over 80%, compared to a 57% drop in the underlying index.

While these "covered call options" funds perform well in stable or rising markets, they underperform in rapid market declines as the additional income from selling options cannot offset the decline in underlying stocks.

Furthermore, as the CBOE Volatility Index soared, some funds shorting the index suffered heavy losses, with ProShares Short VIX Short-Term Futures ETF (SVXY) seeing almost all its accumulated gains since the end of 2023 wiped out overnight.

Once the stock market crashes, the "shorting volatility" strategy may completely fail

"These funds don't like volatility," said Ronald Lagnado, research director at Universa Investments, a fund specializing in hedging severe market downturns. "They call it an income strategy, but in reality, they are just shorting volatility. This can be effective for a long time, but it may completely collapse in a severe market crash **"

The defensive power of "covered call options" has gained attention in 2022, when both the stock and bond markets entered a slow and stable downward period. However, Lagnado stated that in the long run, their performance is not much different from the classic 60/40 stock and bond portfolio.

Nomura Securities analyst Charlie McElligott has long been focused on "shorting volatility" trades and other strategies adopted by systematic traders and quantitative funds. He has warned that the aggressive unwinding of these positions could trigger a "volatility event," causing the VIX to soar to crisis levels.

Ultimately, this prediction came true on Monday of this week.

Market analysts point out that "shorting volatility" trades are not the only strategies impacted. Yen carry trades and bullish bets on tech giants have also suffered significant losses in the recent market turmoil.

As the market collapses, investors' demand for hedging has reached historically panic levels. Compared to call options, put options are more popular, and this preference shift has led to a sharp increase in the Put skew index, which measures the difference in demand between put and call options.

At the same time, the VVIX index has also risen, reflecting increasing investor interest and demand for options related to the VIX index and future contracts based on it.

For example, the Put skew index, which measures the market's implied volatility skew in options, and the VVIX index, which measures VIX volatility.

Along with the rebound in US stocks, traders are re-entering the short army

While some traders are licking their wounds, McElligott stated that with the rebound in US stocks, some traders are re-entering the action of shorting volatility.

Data he provided shows that after the VIX soared, shorting volatility trades historically brought attractive returns, with median data showing a VIX drop of over 60% a year later.

According to Dow Jones market data, the VIX has dropped by over 41% in the past two days to 22.83, potentially marking the largest two-day decline on record