“Relative value” fund blowup product of the day: Capped vs Uncapped Variance. https://twitter.com/bennpeifert/status/1246595988199837696

Standard index variance is uncapped (unlimited potential payoff). Capped variance has a maximum payoff based on 2.5x the initial vol strike, eg min(RV, 2.5K)^2 - K^2.

A standard “Alternative Risk Transfer” product was a simultaneous buy of capped variance and sale of uncapped variance (from the client perspective; opposite for the bank). Typical maturity of 1 month.

The spread between the two (around 1 vol point back in 2013-14; more like 0.4 in early 2020) is just carry for the buyside client, unless volatility rises by more than 2.5x month over month, upon which its Armageddon for the client.

This is equivalent to selling a call option on variance with a far-OTM strike of 250% of the current variance swap level. A March maturity trade done in mid February would have lost 200+ times vega notional (for a trade with carry of 0.4 times vega notional).

Naive backtests looked at 2008 and said hey, these things didn’t lose money. That’s because volatility only rose *almost* 2.5x month on month... which happened to be how 2008 went; but certainly there is no reason volatility can’t rise faster than that...

Final note here... this isn’t just an issue of “short volatility”. Call overwriting is short volatility, quite boring and not remotely at risk of blowing up your entire firm. Don’t over-generalize. Insane tail selling is a category all to its own.