Portfolio Hedging using VIX Calls Explained

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Portfolio Hedging using VIX Calls

When the VIX is low, the negative correlation of the highly volatile VIX to the S&P 500 index makes it possible to use VIX options as a hedge to protect a portfolio against a market crash.

To implement such a hedge, the investor buys near-term slightly out-of-the-money VIX calls while simultaneously, to reduce the total cost of the hedge, sells slightly out-of-the-money VIX puts of the same expiration month. This strategy is also known as the reverse collar.

The idea behind this strategy is that, in the event of a stock market decline, it is very likely that the VIX will spike high enough so that the VIX call options gain sufficient value to offset the losses in the portfolio.

Implementation

To hedge a portfolio with VIX options, the portfolio must be highly correlated to the S&P 500 index with a beta close to 1.0.

The tricky part is in determining how many VIX calls we need to purchase to protect the portfolio. A simplified example is provided below to show how it is done.

Example

A fund manager oversees a well diversified portfolio consisting of thirty large cap U.S. stocks. For the past two months, the market has been climbing steadily with the S&P 500 index climbing from 1273 in mid-March to 1426 in mid-May. At the same time, the VIX has been drifting downwards gradually, hitting a five month low of 16.30 on 17th May. The fund manager thinks that the market is getting too complacent and a correction is imminent. He decides to hedge his holdings by purchasing slightly out-of-the-money VIX calls expiring in one month’s time. Simultaneously, he sells an equal number of out-of-the-money puts to reduce the cost of implementing the hedge.

  • For simplicity’s sake, let’s assume the value of his holdings is $1,000,000.
  • The S&P 500 Index stood at 1423.
  • The VIX is at 16.30.
  • June VIX calls, with a strike price of $19, are priced at $0.40 each.
  • June VIX puts, with a strike price of $12.50, are priced at $0.25 each.
So, how many VIX calls does the fund manager need to buy to provide the necessary protection?

According to the CBOE Website, on average, the VIX rise 16.8% on days when the S&P 500 index drops 3% or more. This means that if the SPX move down by 10%, the VIX can potentially shoot up by 56%. To play it safe, the fund manager assumes that the VIX will rise by only 40% when the SPX drops by 10%. This means that, in theory, the VIX should rise from 16.3 to 22.8 if the S&P 500 drops 10% from the current level of 1423 to 1280.

  • When the VIX is at 22.8, each June $19 VIX call will be worth $380 ($3.80 x $100 contract multiplier).
  • 10% of the fund manager’s portfolio is worth $100,000.
  • Number of VIX calls required to protect 10% of the portfolio is therefore: $100,000/$380 = 264
  • Total cost of purchasing the 264 VIX June $19 calls at $0.40 each = 264 x $0.40 x $100 = $10,560
  • Premium received for selling 264 June $12.50 VIX puts at $0.25 each = 264 x $0.25 x $100 = $6,600
  • Total investment required to construct the hedge = $10,560 – $6,600 = $3,960
S&P 500 Index VIX Call Options Value Put Options Value Net Premium Received Unhedged Portfolio Hedged Portfolio
1210
(-15%)
26.08
(+60%)
$186,912 $0 $182,952 $850,000 $1,032,952
1280
(-10%)
22.80
(+40%)
$100,320 $0 $96,360 $900,000 $996,360
1352
(-5%)
19.56
(+20%)
$14,784 $0 $10,824 $950,000 $960,824
1423 16.30 $0 $0 -$3,960 $1,000,000 $996,040
1494
(+5%)
13.04
(-20%)
$0 $0 -$3,960 $1,050,000 $1,046,040
1565
(+10%)
9.78
(-40%)
$0 $71,808 -$75,768 $1,100,000 $1,024,232
1636
(+15%)
9.78**
(-40%)
$0 $71,808 -$75,768 $1,150,000 $1,074,232

** – Based on historical data, the VIX does not stay below 10 and we assume the same for this example.

As can be seen from the table above, should the market retreat, as represented by the declining S&P 500 index, the negatively correlated VIX move upwards at a much faster rate. The VIX puts sold short will expire worthless while the value of the VIX call options rise to offset the loss of value in the portfolio.

Conversely, should the market appreciate, the rise in his holding’s value is offset by the rise in the value of the VIX put options sold short. Notably, because the VIX has traditionally never gone below 10 for long, the put options sold short should not appreciate too much to cause significant damage to the portfolio. Hence, it is more favorable to implement this hedging strategy when the VIX is low.

In the event that the VIX spiked sharply (not impossible, given that the trading range of the VIX is 10 to 50), the rise in value of the VIX calls can even exceed the losses taken by the portfolio, resulting in a net overall gain.

Note: For the above example, transaction costs are not included in the calculations. Additionally, the following assumptions are made:

  • Full correlation (beta of 1.0) between the portfolio and the S&P 500 index.
  • The rise/fall of the market occurred on option expiration date.

Things to remember

Unless very near expiration, VIX option prices reflect the forward VIX rather than the spot VIX. To discover the forward VIX, one can refer to the VIX futures price.

Historically, the VIX only move opposite the SPX 88% of the time. So this means there is still a 12% chance that the negative correlation will not materialise. So, unlike hedging with index puts, the protection is not 100% guaranteed.

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Using VIX Options to Hedge Your Portfolio

According to CBOE, The CBOE Volatility Index® (VIX® Index®) is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices. Since its introduction in 1993, the VIX Index has been considered by many to be the world’s premier barometer of investor sentiment and market volatility.

Introduction

Several investors expressed interest in trading instruments related to the market’s expectation of future volatility, and so VIX futures were introduced in 2004, and VIX options were introduced in 2006.

Options and futures on volatility indexes are available for investors who wish to explore the use of instruments that might have the potential to diversify portfolios in times of market stress.

VIX is a great way to hedge your long portfolio. It is a well known fact that during severe market downturns, VIX spikes significantly, which can offset some of your portfolio losses. However, you cannot trade VIX directly. There are few ways to trade VIX:

Of course if you buy VIX calls and volatility spikes, you can make some significant gains. But most of the time, those calls will lose money due to the fact that VIX drift lower, and those options will lose value over time.

Possible solution: VIX strangle

This article describes the following strategy of going long VIX:

  1. Purchase VIX put options that expire 3 months out and are 2.5% out of the money and simultaneously buy 4th month call options that are 20% out of the money. These positions are established each month on a date that is half way between the 3rd and 4th month expiration dates. Two months later these option positions are rolled.
  2. The put leg of the calendar strangle can help reduce the cost of the long call. Typically, when hedging through purchasing an out of the money call option on VIX to gain protection against tail risk there can be an undesirable carrying cost for the position. In periods of low volatility the long put position will benefit from the term structure of VIX futures pricing as the time to expiration for the option approached expiration. The long call position will be in place to potentially benefit from market conditions that result high higher implied volatility for the market as indicated by VIX.

The general idea is that short term futures are declining faster than long term futures, and if VIX stays stable, the put gains will offset the call losses. Basically the strategy will roll the trade every two months.

Expected results

During calm periods when VIX stays stable or drifts lower, we can expect the trade to produce 10-15% gains or end up around breakeven because the puts gains will offset or slightly outpace the calls losses.

However, during periods of volatility spike, the calls should gain significantly, and in some cases, the whole structure can deliver 50-100% gains. This is basically a cheap way to go long VIX and hedge your long portfolio, without experiencing losses during calm periods.

We have made several changes to the strategy in order to better adapt to the current market conditions.

Want to see how we implement this strategy in our SteadyOptions model portfolio?

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