Everybody's Doing it: Short Volatility Strategies and Shadow Financial Insurers

The extraordinary growth of short volatility strategies creates risks that may trigger a serious market crash. A low-yield, low-volatility environment has drawn various market participants into essentially similar short volatility-contingent strategies with a common nonlinear risk factor. We discuss these strategies, their commonalities, and the generally unrecognized risks that they would pose if everyone were to unwind simultaneously. Volatility-selling investors essentially provide “shadow financial insurance.” Investors and regulators would benefit from preparing for large, self-reinforcing technical unwinds that may occur when/if central banks change policy or macro or political events affect investor confidence. We also discuss potential mechanisms that might provide stabilization against largely adverse financial outcomes.