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Summary

  • Relative to realized volatility levels in the S&P500, VIX is not providing cheap protection as characterized by financial media.
  • Understanding volatility of VIX is critical before employing hedging strategies, as subsequent returns are low if protection is bought at high levels of VVIX.
  • Current term structure in VIX has dampened the leverage provided by VIX calls or SPY puts.

Recent financial crisis provoked an interest in tail risk hedging strategies which create positive payoffs during financial turmoil, creating widespread popularity of VIX. Broadly known as "investor fear gauge" VIX measures 30 days expected volatility of the S&P500 (NYSEARCA:SPY) index by averaging the weighted prices of SPX puts and calls over a wide range of strike prices. VIX combines the information reflected in the prices of all selected options; where in the contribution of a single option is inversely proportional to the square of the option's strike price. Historically, during periods of market turmoil, VIX spikes higher, reflecting panic demand for SPX puts as a stock portfolio hedge. During bullish periods, there is less fear, reducing the demand for portfolio protection. However, investing community should be cynical about the efficacy of portfolio hedging through VIX because the increased demand for tail risk hedges after financial crisis has made them more expensive.

Before taking a dive in the efficacy issues, let us look at the volatility realized in the S&P500 since 1999. The chart below succinctly points out the peaks in realized volatility levels seen during the market turmoil of 1999-2003, 2008 financial crisis and US debt downgrade in 2011.

(Source : Yahoo Finance for index data)

Obvious from this chart is the strong correlation between the volatility regimes and the economic cycles. Economic growth reduces confusion whereas recessionary phases provoke fear, affecting the inherent risk premium participants charge for providing the insurance. Research studies have found long-term mean for implied volatility (represented by VIX) is 20.27 percent and mean for realized volatility is 16.38 percent, confirming inherent risk premium of almost 4 points in index options over realized volatility levels seen in the index. Table below presents the average 30 day realized volatility seen in the S&P500 index over different time periods.

Time Period

Mean Realized Volatility, in percent

Jan 1999 to Current

17.9

Jan 2004- Dec 2007

11.5

March 2009 to Current

15.9

May 2012 to Current

11.7

As noticed in the table above, realized volatility over a 30 day period in the S&P500 during 2004 to 2007, the bull market averaged around 11.5, similar to the levels we are seeing. However, for the last several quarters, growing economic volatility has not translated into stock market volatility- depressing the levels of VIX. Also, an impressive performance by equity markets in 2013 is drawing huge interest from financial media, advising investors to load up on these tail risk hedges. While I don't disagree on low levels of VIX, I remain skeptical on cheap premium levels as characterized by financial media. In fact, the decline in VIX index levels has led to the steepening in term structure of VIX futures as shown in the chart below.

(click to enlarge)

(Source: VIX Central)

Steep term structure implies the risk premium market participants are charging for providing the portfolio insurance over the long-term. In addition, investors should also review volatility of VIX (VVIX) which highlights the demand for tail risk. Higher level of VVIX implies expensiveness of tail risk hedging assets. One standard deviation move in VVIX is associated with decline in the S&P500 put and VIX call returns. Presently, the lower spread between VIX and realized volatility levels is a result of theta decay in the options before a long weekend lowering the index levels. Current level of premium charged has raised the break even hurdle and overestimates the leverage provided.

Before loading up on these hedges, investors should align their view on market direction with a view on volatility expected. For example, if you expect a slow decline in the equity markets, you can create trading strategies which combine your view on low volatility and a negative bias. OTM put calendars let you express short volatility and negative directional bias together. If you believe the market is under pricing the volatility and expect a steep decline in the market, you can express your opinions through plain vanilla OTM puts, back spreads. If you expect downside skew to steepen but are concerned over theta decay, you can sell OTM calls to buy OTM puts.

Source: Demystifying The VIX Myth