Protecting Your Portfolio With Implied Volatility

Includes: SPY, SVXY, VXX
by: AlphaVN Research

The global equity rally in developed nations has created significant headwinds for implied volatility. Implied volatility (IV) is the market's estimate of how much a security will move over a specific period of time on an annualized basis. IV moves based on market sentiment and current elevated levels of complacency has pushed IV down to historically low levels. The issue for many who are looking for protection is that most of the available options that can be used to hedge a portfolio are either difficult to manage or unprofitable, but there is a technique that can be used to assist in protecting one's portfolio.


The most common benchmark of implied volatility is the VIX volatility index, which measures the levels of implied volatility for at the money calls and puts on the S&P 500 index (NYSEARCA:SPY). Low levels of IV express complacency and make "at the money options" relatively inexpensive. High levels of IV express fear and generally make "at the money options" expensive.

Many portfolio managers use S&P 500 options to hedge their risk. Purchasing protective puts will effectively hedge a portfolio, but investors need to actively manage these positions and determine the appropriate premium they are willing to spend for said protection. Another solution is to purchase VIX futures or a VIX ETF (NYSEARCA:VXX), but the term structure of these instruments can make this strategy very expensive.

Term Structure

The term structure of a futures curve shows the relative levels of each futures contract with respect to time. The term structure of the VIX futures is in deep contango -- deferred contracts are more expensive than prompt contracts. This contango reflects the time decay related to options pricing, cf. the Black-Scholes equation. The longer the tenor of an option, the more expensive the options is to purchase.

One issue with VIX ETFs is that they hold futures contracts and need to consistently roll from a prompt futures contract to a deferred futures contract prior to the expiration of the nearby contract - known as 'rolling forward.' Rolling forward like this is expensive and is a losing proposition generally. The VXX ETF lost more than 77% in value during 2012. Investors who purchase VIX ETFs over the long term always face losing money due to the time decay of S&P 500 index options. In a market where the central banks are actively managing volatility downward this effect is only amplified.

Potential Solution

One solution, if available, is to try and hedge with an inverse VIX ETF (NYSEARCA:SVXY). Instead of purchasing the inverse of the VIX an investor could short the inverse. By shorting an inverse ETF, you are taking a long position in the VIX without facing the drain of time decay.

The SVXY ETF has climbed to new highs as implied volatility has declined. The VIX is bound by zero, which limits the upside of short VIX ETFs. If equity markets begin to decline and implied volatility increases significantly, the short VIX ETF will decline with them. The issue an investor faces using this strategy is the cost of borrowing a short VIX ETF, which could be expensive depending on your broker.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.