Hedging Provides Relatively Cheap Insurance For Volatility ETPs

Jun.24.14 | About: ProShares Ultra (UVXY)


Limit your downside risk to between 6-12% with hedging strategies.

Using visual charts, I will explain how to execute each strategy.

Never invest in UVXY or SVXY without a hedging or stop loss strategy.

When would you use each strategy?.

In writing articles on the VIX futures ETPs (Exchange Traded Products), a common question I receive is about hedging. I encourage you to read my other articles for more background information on the VIX futures. I also highly appreciate all my readers!

Volatility doesn't always go the way you think it is going to go. Many volatile ETPs have proven this over the last two months. I have spoken to users who confided losses of over 40% and are still hanging on, hoping to gain back part of their investment. I never wish that feeling on anyone. In my early naive days of trading volatility, I too made some of the same mistakes.

Whether you are shorting volatility at these low levels or speculating that a spike will soon occur, you can use these strategies to prevent significant capital losses.

I have been pretty vocal about my recommended strategies in volatility. Focus on the downside instead of the upside. However, if you must trade volatility now, please take some of this advice into account and limit your downside risks.

We are going to look at two hedging strategies you can use with ProShares Ultra VIX Short-Term ETF (NYSEARCA:UVXY). This strategy could also be used with the following ETPs:

iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA:VXX)

ProShares VIX Short-Term Futures ETF (NYSEARCA:VIXY)

We will also look at one hedging strategy you can use with ProShares Short VIX Short-Term Futures ETF (NYSEARCA:SVXY).

It is important to note that ETPs must be optionable to use the strategies we are going to discuss today. The option only provides insurance for your initial investing strategy.


Strategy One

If you are speculating on an increase in volatility and you want downside protection, this is the strategy for you.

Timing: This strategy would be best suited for periods of relatively low volatility leading into a spike in the VIX futures.

First, directly purchase shares of UVXY. Current market price at the time of writing was $28.63.

For this example, you are going to purchase 1000 shares. A total cost of $28,630.

The first question you must answer for yourself is, how long are you going to hold this position? The longer the holding period the higher the insurance premium is going to be. I recommend setting up trades in UVXY with no longer than a one month exit window.

Say you expect a volatility spike within two months. The ideal option for hedging is going to be the 1 August 14 weekly put option (40 days of protection) or the September 14 put option (89 days of protection).

My recommendation is to purchase the 01 August 2014 weekly put option with a $30 strike price. Why purchase the $30 strike price and not the $25? Answer: It provides more downside protection.

Here is a visual of how strategy one would perform:

Click to enlarge

Chart courtesy of Optionshouse.com.

The downside risk has been mitigated to -$3526.27 over a 40-day period. In percentage terms, this would be a loss of 12.31%. That is still a significant downside risk in my opinion. However, UVXY is down 37.31% over the last 40 days. Those holding UVXY since then would gladly take a 12.31% loss over their now 37.31%. You can always exit the position early if things are not going your way. This would further mitigate your downside risk to below 12%.

Strategy Two

If you are speculating on decreasing volatility by shorting UVXY, then this strategy is for you.

Timing: This strategy would be best suited for periods of relatively high volatility. Ideally, the VIX futures would be moving from backwardation into contango.

For strategy two, we are going to use the same 1000 share example, at $28.63 per share. By shorting UVXY, you receive $28,630.

To hedge against an upside move in volatility, you can purchase front month Calls. Again, we will use the 01 August 2014 Call option with a strike price of $28.00. The $28 option offers the least downside risk.

Here is a visual:

Click to enlarge

Chart courtesy of Optionshouse.com.

This strategy limits your downside risk to $3470. Of your $28,630 investment, it represents a loss of 12.12%. UVXY can increase, at certain times, over 1000% (such as 2008). This would lead to losses in excess of 100% of your initial investment.

My personal advice is to not short volatility at the currently low levels (10.85 at time of writing). Wait until volatility has spiked to short. You can review that strategy here.


Strategy One

If you are speculating that volatility will stay the same or decrease, this is another strategy for you.

Timing: This strategy would be best suited for periods of relatively high volatility. Ideally, the VIX futures would be moving from backwardation into contango.

At the time of writing, SVXY is currently trading at $85.62 per share. In our example, we are going to assume you purchase 400 shares for a value of $34,248.

To hedge this strategy you would purchase 4, 01 August 14 $86 Put options.

Here is a visual:

Click to enlarge

Chart courtesy of Optionshouse.com

Your maximum downside risk in this trade is $2,240. This represents a loss of 6.54%.

Final note: You should factor in the cost of commissions and margin (when shorting) into each trading strategy. Both UVXY and SVXY can experience high gains and losses in short periods of time. Shorting UVXY can result in losses exceeding 100% of your initial investment. Timing is important and you can refer to previously articles I have written in regards to timing, here.

Each strategy can be adjusted to tailor your specific risk tolerance. Hedging with options further out of the money can reduce your cost of insurance, but increase your maximum losses. If timed correctly, cheap insurance can go a long way to protect your capital.

In lieu of this strategy, I recommend a stop loss to ensure capital preservation in an unexpected event.

I would never invest in UVXY or SVXY without a stop loss or hedging strategy.

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

Additional disclosure: This is not an options strategy. This strategy is meant to hedge your initial investment in various volatility ETP.