Why then did we bother to hold positions that paid out massively in the event of the collapse in these instruments and why in the size that we did? The short answer is convexity, asymmetric payoffs, hedging and the mispricing of tail risk.
Below are 2 VERY good articles on volatility contractions and explosive moves (and ETF blow up).
Low volatility or vol is positively correlated with investor complacency and investor complacency is negatively correlated with good risk-adjusted returns.
Will we see another SHORT VOL BLOW UP ? The question is not if, but when.
Equity volatility has fallen significantly over the past year, with the VIX index declining from an average of 26 in 2022 to just 17 in 2023.
The 9 pt year-over-year decline ranks as the 3rd largest annual drop in equity volatility on record, behind only 2010 (post-GFC) and 2021 (post-covid) !
So far, 2024 looks to be much of the same, with the VIX index averaging just 13.5 YTD, well below levels we saw even pre-pandemic.
First article:
On Option Income Funds and Volatility - Cboe Derivatives Market Intelligence: https://go.cboe.com/l/77532/2024-03-12/fhj6l5/77532/1710265470Q3fF96oT/Option_income_ETFs_Updated_20240312b.pdf
Second article:
The 2018 Short Vol blow up: https://houndstoothcapital.com/2018/05/06/anatomy_of_a_blowup/
Good night and good luck!
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