The notion of nothing is one thing that the market loves to talk about at present, . I mean nothing in the sense of there being low vol. By which ever metric you choose, implied vol seems low. VIX is sheltering in the 10 area, whilst in FX, EUR/USD 1M implied vol is on a 4 handle, spurred by central banks which have presided over a period of easy monetary policy.
If vol is so low and is intrinsically mean-reverting, we might expect vol to rise. The problem is of course that the precise timing is tricky, which requires a trigger. In terms of "known" triggers, one of the most likely candidates for this are Fed hikes (I won't pretend that I can guess the "unknown" triggers. The difficulty with long vol trades is that they are negative carry. Hence, if your timing is wrong, you could well bleed for an extended period of time, which could well outweigh gains you make when the market eventually goes bananas. After all, we can remain in an extended period of depressed or falling vol. Simply look at how vol has behaved over the past few years.
The key point however, is that it is not just implied vol, that impacts P&L of a gamma trader. In particular, we need to recall that for a gamma trader, what is most important, is not simply where implied is, but the differential between realised and implied (strictly speaking if we are trading gamma through vanillas and delta hedging this difference is gamma weighted). This differential is the volatility risk premium. Indeed, this point was made by Matt Levine recently on Bloomberg View, where he discussed it from a VIX angle. Typically, the volatility risk premium is positive, given that implied tends to be above realised. After all, traders selling vol need to be rewarded for selling insurance. In the plot above, we have shown EUR/USD 1W implied - realised volatility, to illustrate this point.
Obviously, the issue with being short gamma is that if realised vol blows up above implied, you are faced with a nasty drawdown. We can to some extent mitigate this drawdown, by delta hedging (as opposed to nakedly selling straddles). If realised manages to remain relatively well behaved, we should still make money regardless of where implied goes. If anything, when the volatility risk premium blows up, it gives us a chance to harvest additional premium from being short gamma.
So next time we hear about vol being depressed, I'll be taking a look not just at implied but also how it is trading versus realised. Just as drawdowns are the drawbacks for short gamma trades, so the gradual bleed can impact long gamma trades.
To read more about this topic please see the below work I've done, which goes through the subject in more detail, including systematic strategies for trading gamma in FX. My book Trading Thalesians also has a chapter on measuring risk (mixed in with a bit of ancient history).
Thalesians - Gamma, gamma, gamma - Explaining gamma trading in FX markets- 14 Apr 2014 (available for Thalesians clients only)