Short Volatility Risk

Short volatility risk is the financial danger incurred by traders or protocols that sell options or structured products to collect premiums. When an entity sells volatility, they essentially bet that the price of an underlying asset will remain stable or move within a narrow range.

If the market experiences a sudden, sharp move, the value of the sold option increases rapidly, forcing the seller to buy back the position at a much higher price, often resulting in catastrophic losses. In cryptocurrency, this is exacerbated by high leverage and the lack of deep liquidity during market crashes.

This risk is central to liquidity provision in automated market makers where liquidity providers are inherently short volatility. It is a classic example of picking up pennies in front of a steamroller.

The risk is realized when implied volatility spikes, causing a gamma trap for the seller.