Take a look at the following chart. What is your inclination: long or short?

(Click on image to enlarge)

If you said short, you’re in large company, for shorting volatility is in vogue like never before. And this particular product, which uses 2x leverage in going long volatility (ticker: TVIX), has been a favorite among short sellers.

Why? Because it only seems to go in one direction: down.

Since its inception in November 2010, it is down 99.99995%, about as close to 0 without actually hitting it as you can get. From a split-adjusted level of over 28 million at inception (no, that’s not a typo), it closed yesterday at around $12 per share.

Why doesn’t everyone short TVIX?

Good question, and one that I have received with increased frequency over the past month as reports of traders making millions shorting volatility have gained widespread publicity.

To answer that question, let’s do a theoretical exercise. If one could go back in time with the knowledge that TVIX would be down 99.99995%, would you short it with everything you have?

If volatility always went down, I suppose you might. But as we know, it doesn’t. From time to time, volatility spikes higher, sometimes dramatically so. And when it does, shorting volatility can be treacherous. Add 2x leverage and treacherous can quickly turn into ruinous.

Since the inception of TVIX, these are the largest run-ups or spikes…

And these are the largest 1-day spikes…

As you can see, these are not small percentage moves.

Why that’s important will be clearer after we discuss some of the mechanics and math behind short selling…

When you sell a security short, you are borrowing someone else’s shares, selling them, and hoping to profit by buying back in at a lower price (after which you return the borrowed shares). If you have $100 and sell 1 share of a security short at $100 and it goes to $50, you make a $50 profit. Assuming no transaction costs or fees to borrow the shares (for the sake of simplicity), this would be a 50% profit.

If instead of going lower, the security goes higher, losses start accruing. Unlike a long position where losses are capped at 100%, your losses from short selling are theoretically unlimited. If a security doubles in price (a 100% gain), you lose everything. If you have $100 and sell 1 share of a security short at $100 and it goes to $200, you lose $100, or 100% of your equity. If a security goes up more than 100%, you owe money to the broker.

In practice, this should never happen, as your broker would issue a margin call well before it got to the point where you owe them money. In a margin call, they will ask you to raise cash by selling shares to reduce your exposure. This requires booking losses as you are selling when you are down. If you don’t meet that call, they will meet it for you by liquidating some or all of your position.

With TVIX, it’s easy to see how shorting it with everything you have can lead to ruin if it is done at the wrong time. In 2011 when the S&P 500 declined just over 20%, the volatility index spiked higher, more than tripling from its level in early July.

(Click on image to enlarge)

You’ll notice in table above that TVIX went up over 531% during this period, or 6x its initial value. Needless to say, shorting TVIX with 100% of your account would have not only wiped you out but put you into negative territory. A $100,000 short position would result in a liability of $431,375 to your broker.

As we discussed, though, it would never have come to this point, unless there was a substantial overnight gap up in price. Barring such a gap up, once the equity in your account dipped below a certain level (what’s known as the maintenance margin), they would require you to start selling down the position, booking losses until it meets the requirement. At Schwab, the maintenance margin for 2x leverage ETFs on the short side is 60%, meaning if the equity in your account dips below 60% of the value of your short position, you will be forced to start liquidating.

The maintenance margin can be raised at any time and varies from broker to broker. Interactive Brokers recently raised their volatility margin requirements, making it much more difficult to short leveraged ETFs with any size. Other brokers have followed suit, limiting their risk in the event of a large one-day spike.

So why doesn’t everyone short volatility with everything they have?

Because most people do not want incur the risk of losing everything, which would have been the result back in 2011, 2015, and 2016 (assuming no margin calls). In order to avoid the possibility of such a catastrophic loss one would need to significantly lower their exposure to the short volatility trade. How much lower would it have needed to be in order avoid a 100% loss? Around 18% in the case of a 2011, but remember, that was only a 20% decline in the stock market.

If TVIX was around in 2008, it likely have been up well over 1000%, meaning even a 10% position would be wiped out.

None of this suggests that one cannot make money shorting volatility. You certainly can make money and will do so more often than not as markets tend to rise more than they fall and the VIX futures curve is in contango more often than backwardation (for more on why this matters when it comes to VIX ETFs, click here). But more often than not is far from always. The high theoretical returns from shorting volatility are not a free lunch. They come with substantial risk of short-term and potentially catastrophic losses.

Such risks are easy to forget in an environment like today, one of the least volatile years in history.

But the absence of volatility does not mean the absence of risk. Just because the past 15 trading days have been the most peaceful days in history one cannot imply that things will remain peaceful forever.

Hence the following public service announcement: if you are thinking about shorting volatility today, truly understand the risk you are taking and ask yourself if you’re willing to accept the possibility of a substantial and even catastrophic loss.