Using the VIX as a Hedging Tool

I generally use the VIX as a speculative vehicle rather than a hedging tool, but lately I have received several questions about how one might go about hedging a portfolio with the VIX. The subject of hedging is going to require a series of posts in order to do it justice, but before I dive in, I thought I should share an interesting paper from Edward Szado that recently became available on the web site of the Center for International Securities and Derivatives Markets ((CISDM)) at the University of Massachusetts.

In Szado’s own words, his paper “assesses the impact of a long VIX investment as a diversifier for a typical institutional investment portfolio during the 2008 credit crisis. The analysis covers the period of March 2006 to December 2008 (beginning shortly after the introduction of VIX options in February of 2006) with a focus on the latter part of 2008 (from August to the end of December).”

The research utilized by Szado incorporates three different long VIX hedging strategies.

• VIX futures (near month, 2.5% and 10% allocations)
• VIX at-the-money calls (1% and 3%)
• VIX 25% out-of-the-money calls (1% and 3%)

The full text of Szado’s conclusion is as follows:

Ultimately, the goal of this study is not to make a strategy recommendation for an ongoing risk management program, but rather to consider the impact that a long VIX exposure would have had in this particular time period. The increased correlations among diverse asset classes in the latter half of 2008 generated significant losses for many investors who had previously considered themselves well diversified. It is clear from the results of the analysis that, while long volatility exposure may result in negative returns in the long term, it may provide significant protection in downturns. In particular, investable VIX products could have been used to provide some much needed diversification during the crisis of 2008. In addition, the results of this study suggest that, dollar-for-dollar, VIX calls could have provided a more efficient means of diversification than provided by SPX puts.

Going forward, I will discuss in more detail the approach and data from Szado’s study and offer some of my thoughts about using various VIX products for the purpose of hedging.

Comments

[Robert Mart...:]

Bill: Thank you for this suggestion.
Page one of the WSJ today noted the "failure of traditional asset allocation" has caused investors to rethink their basic assumptions about diversification.

Looking ahead, investors will have to use new tools to diversify, and buying VIX calls makes a lot of sense: It's transparent, liquid, and has good potential for negative correlation just when you need it most.

I look forward to your future posts on this topic.
Rob

Jul 10 08:36 AM

[TCK:]

I look at the VIX whenever I see a post regarding strategies. However, I just can't get past the idea of paying the 20 to 40 cent spreads on the bid/ask. Of course this is in and out.

I would like another way to play the same sentiment without the "slippage".

Jul 10 08:39 AM

[Baboon:]

The best way to hedge long stocks is to sell SPX calls.

Jul 10 11:05 AM

[Paul H. M.:]

The high bid/ask price is because they are European style, so they can't be exercised early. That makes them less liquid, since less brokers are willing to purchase contracts that cannot be used at any time.


On Jul 10 08:39 AM TCK wrote:

> I look at the VIX whenever I see a post regarding strategies. However,
> I just can't get past the idea of paying the 20 to 40 cent spreads
> on the bid/ask. Of course this is in and out.
>
> I would like another way to play the same sentiment without the "slippage".

Jul 23 02:55 AM