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People owning individual stocks or ETFs like SPDR S&P 500 (NYSEARCA:SPY) or iShares Russell 2000 Index (NYSEARCA:IWM) always are looking to hedge their portfolios against a market crash. I have been looking for a perfect hedge for years. I don’t think it exists. Some strategies will work better in certain markets and not work in others.

In this article, I would like to present some alternatives and discuss their pros and cons.

VIX, created by the Chicago Board Options Exchange in 1993, is the Volatility Index. VIX was originally constructed using the S&P 100 index, but in 2004 CBOE switched to the S&P 500 to capture a broader segment of the overall market.

The VIX was designed to measure expectations for volatility. The VIX has a significant inverse correlation to the price action in the S&P 500. The inverse correlation would make the VIX an excellent hedge for traders and investors. The problem is that VIX itself is not a tradable vehicle.

To overcome this problem, you can trade VIX options. This might be a good solution in the short term, but can be very expensive to maintain over time due to the time decay of the options.

This brings us to the next possible solution – VXX. The iPath S&P 500 VIX Short-Term Futures (NYSEARCA:VXX) maintains a rolling long position in the first and second month VIX futures contracts. The VXX ETN must continually update its portfolio to include more long dated futures and fewer short term futures. Longer dated volatility futures are usually more expensive than short term, so the VXX operators are continually buying dear and selling cheap. This causes the VXX to lose value over time, assuming all other factors equal. In addition, in case of big VIX spike, VXX will most probably spike less since it is based on the VIX futures and not VIX itself.

The next step would be to try to capture some time decay during “calm” times when VXX is stable or slowly drifting down. Our goal is to earn nice profits when VXX spikes and at least not to lose money during calm times.

The idea is to buy 3-6 months VXX DITM (Deep In The Money) call and sell a weekly ATM (At The Money) call against it every week. We are buying the VIX calls and not the stock itself to reduce the cost and to increase the percentage return of the trade.

With VXX currently trading around $39, this can be done in the following way:

  • Buy VXX June 2012 25 Call at $15.80.
  • Sell VXX Dec 23 (weekly) 2011 40 Call at $1.10.

The long call has delta of 89 so it should produce a fairly close replication of VXX move. The short call has delta of 42. So the total delta of this position is around 57. The trade should do very well if VXX spikes. If VXX stays stable or declines, you continue selling ATM or slightly OTM calls every week. After 12-15 weeks, you own the June call for free.

The only problematic scenario I see with this approach is a very quick and very sharp spike in VXX. If this happens, the weekly option will become very close to 100 while the long term option delta is still slightly less than 100. In this case, you capture some initial gains but after certain point the gains start to shrink slightly. In the last three years, this happened only once, in May 2010. Even in August 2011 the spike was more gradual and would give you a chance to roll the short option to a higher strike. The reason for the spike being more gradual is a slower rate of increase in VXX compared to VIX.

I would love to hear some feedback from people who tried different ways of VIX/VXX hedging.

Source: A Different Way To Hedge With VXX