It happened again, and again.
Last Thursday volatility increased sharply at around 1.30 p.m, then it came back to normal at the end of day. For now, we ignore the cause. But this event reinforced our observation: sharp volatility spikes occur more and more frequently these days.
[caption id="attachment_382" align="aligncenter" width="590"] Volatility on July 27, 2017. Souce: InteractiveBrokers[/caption]
In a low volatility environment like this one, market participants are becoming more and more aware of the potential risks caused by the volatility feedback loop which will happen when the short volatility players are forced to deleverage. Sharp spikes in volatility are usually caused by unanticipated, black swan type of events. According to Steve Cucchiaro, the following circumstances can have the potential of leading to black swans
Nobody knows when a black swan will happen. So the right question to ask is: how to protect oneself from the black swan events?
We believe that using VIX options to construct ratio call spreads (for example 1x2 VIX calls) is a sensible solution.
We note that recently, Joe Ciolli of Business Insider presented an example of a hedge against a massive increase in volatility. But according to his post, we think that the trade is risky, so this is not a good hedge.
Alternatively, the trade was constructed and executed correctly, but it was misinterpreted by the journalist.
Originally Published Here: Potential Black Swans and How to Hedge Against Them