Shorting Volatility on the FOMC Announcement

I figured that the Fed will pretty much always be dovish on these meetings.  Unless they are absolutely forced to raise rates, and perhaps not even then, don’t expect any concrete moves towards higher interest rates anytime soon.  At best they may talk the talk of the potential for raising rates, or following ‘data-driven policy’.  Without the hard backing of actual rate changes, these words are meaningless.  The data itself can be sliced and diced and interpreted so as to give infinite latitude to these bureaucrats.

The market expected dovishness too, based on the volatility chart (VIX).  It increased to only a moderate 14-15.  This is still quite a low level of volatility.  So very few believed that there would be anything unexpected.  Still, it was enough.

Immediately before the meeting, I bought an at-the-money call option on SVXY expiring this week.  This is an insanely risky thing to do under normal circumstances.  It is literally buying an option on options.  An option on volatility-linked ETFs is the financial equivalent of a dirty bomb.

My call was short term bearish on volatility (since SVXY is anti-volatility).  This goes against my general thesis of being long volatility.  I’m a big believer in black swans and the unknowns we don’t know we don’t know.  So ordinarily I’d hate shorting volatility as a short term move.  But given the predictability of FOMC responses, I felt that the risks were justified.  It was essentially financial speculation on politics.

I bought and a few minutes later, the minutes came out.  Rates would not be raised.  The VIX fell immediately.  I vacillated as to whether to sell the call, which had gained value, or whether to hold out for more.  Aware of the extreme time decay of the option I was holding, I opted to sell with a generous 25% profit.

Even though it worked this time, this type of trade should only be entered with a sober understanding of the extreme risks.  I usually assess an investment decision by asking the question “Would I feel stupid if this trade lost money?”  If the answer is ‘No’, it means that I have an investment thesis so sound it can overcome my own emotions.  If the answer is ‘Yes’, the trade is a dangerous one, because if it turns negative, I may start to make mistakes.  Thankfully I didn’t end up having to face that test on this particular trade.  But probably if it had lost money, I’d have felt exceptionally stupid.

As I listened to the remainder of Yellen’s press conference, it struck me as odd that the monotonic utterings of this woman could send markets into such a tizzy.  As her words drearily plodded on, I could see markets gyrating in hair-pin turns.  No doubt fancy algorithms were parsing her words into trades faster than any human could.  Every turn of phrase was reflected instantaneously in the price.  When the video cut out momentarily, I hardly missed it; the price reflected with fatal accuracy the gist of her words.

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