/biz/ - Business & Finance

The New York Times reported Monday that one day trader managed to turn $500,000 into $12 million over five years by shorting a leveraged VIX exchange-traded fund like the ProShares Ultra VIX Short-Term Futures (UVXY).

The story combined with the fact that the CBOE Volatility Index or the VIX has been at historic lows for most of this year might make shorting VIX ETFs an enticing investment strategy, but it's very, very difficult to get it right. Macro Risk Advisors derivatives strategist Pravit Chintawongvanich crunched the numbers and confirmed that it is indeed possible for a simple short strategy to achieve those returns, but requires an iron stomach. In a note published today, he wrote:

Just for kicks, we wanted to see if it would really be possible for someone trading a simple strategy of shorting UVXY (with extremely high leverage) could have achieved these returns over the past 5 years, ignoring the borrow cost on UVXY shares. We are NOT in any way recommending this strategy, this is purely for illustrative purposes (and laughs)! The exact details of the rules are unimportant (since we aren’t pitching this as a viable strategy) – we simply simulated always shorting UVXY with a certain % of one’s money and shorting more when the VIX spiked. The point is that yes, it was possible, but only by taking extreme amounts of leverage and suffering multiple high (60%+) drawdowns. Also, notice how most of the money was made in the past year!
Most importantly, this strategy would not have survived 2008 and in fact it was mostly wiped out long before 2008 even happened. Even looking at 2011, we can see that the strategy would have suffered a 90%+ drawdown. This shows how the past 5 years have been a uniquely good time for shorting volatility, causing these strategies to have a misleadingly high Sharpe ratio. But that high Sharpe conceals the actual danger of running a negative convexity strategy with excessively high leverage.