Vix Futures: A Perfect Hedge For A Long Only Stock Portfolio

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Includes: CVOL, IVOP, SVXY, TVIX, TVIZ, UVXY, VIIX, VIIZ, VIXM, VIXY, VXDN, VXUP, VXX, VXZ, XIV, XVIX, XVZ, XXV, ZIV
by: Gino Bruno D'Alessio

Summary

What we know about the relationship between Vix & S&P 500.

Implementing a Hedge strategy using volatility futures.

Performance of simple long futures and a simple variant.

Correlation between Vix and S&P 500

The Vix index is also known as the fear gauge, notoriously volatility spikes occur most often when the broader stock market falls. We have seen it happen various times. The chart below shows how the Vix index performed over the past 15 years. We can see that each time there has been a selloff in the stock market volatility increases.

Click to enlargeSource Tradingview.com

Looking at the periods between 2000/2002 and 2007/2009 we can see that on both occasions there are large spikes in the level of the Vix index. Even during the small market correction of 2011 and August last year we can see that volatility also spiked.

The next chart shows the Vix and S&P 500 both on the same chart for a direct comparison. The period is rather short, showing the 3rd quarter of 2012. But it is very indicative how these two prices move in relation to each other.

Looking at this in a more quantitative way; over the period going from September 1, 2000 to September 28, 2012 the S&P 500 closed up 1692 times and the Vix over the same period closed down 82.15% of the time. Days with a close down amounted to 1514 during which the Vix closed up 78.40% of the time.

The statistics mentioned above show a very strong negative correlation between the S&P 500 and the Vix indices. Most importantly there is no reason to believe that this relationship should breakdown over time. The theory behind the strong negative correlation is fairly simple; when the stock market starts falling investors start buying options to hedge their portfolios. They of course will be buying Put options to protect the downside. This will push the price of Put options higher, as investors will be willing to pay more to gain coverage as fear sets in. As options are priced in terms of volatility what increases the price of options mostly is exactly volatility.

It would seem now the fundamental reasoning behind this relationship seems to be a stable one. It has repeated itself on various occasions of market stress and there also seems to be a strong statistical correlation. And it would also seem unlikely market psychology would change anytime soon.

Putting on a Vix futures hedge

For ease of use I am going to use the close price of the Vix index for all calculations. The theoretical hedge is implemented by going long of the Vix on the first trading day of the month. In theory you would be choosing the next calendar month futures contract. At the beginning of the next month you would roll the futures position into the following next calendar month contract.

Basically the hedge consists of being permanently long of Vix futures. As we saw earlier the idea is to capture revenue from spikes in volatility when the stock market makes a correction or runs into a bear market. And attempt to protect against large drawdowns in times or market stress.

This strategy is very simple and is more of an exercise to see if there is a potential value of being long volatility, using the Vix index. The choice of the first day of the month to start the hedge is purely arbitrary and starts on January 2004. I chose not to go back further as 2004 was the year the first Vix futures contract was offered, in March.

The hedge strategy can be made as complex as you like by adding rules or changing the timing. You can add: limits on when to go long, rules on when to roll or which calendar month to roll into etc. There will also be considerations to be made with using futures as to the term structure of the futures contracts. Curves in backwardation or contango may have positive or negative effects as you roll your positions.

The next question is what is the hedge ratio, how many Vix contracts do I hedge my stock portfolio with. I kept this simple and suppose you should hedge every $100k of stock with one Vix futures contract.

The performance of a continued long Vix hedge

Performance data is shown in US dollar terms, as creating a percentage return on the Vix futures position would depend greatly on how collateralized the position is. Margin requirements for Vix futures range from $6,215 for the front month to $2,530 for the back months. Plus what is interesting to see is how much revenue your long position in Vix futures generated compared to your stock portfolio.

Click to enlarge

The chart above shows the US dollar return of two long 1 Vix contract strategies and the S&P 500, representing $100k in a stock portfolio. The red bars represent a simple long position which is continuously rolled over into the next contract. The green bar represents the same long only position in Vix with an added rule; when Vix is above 50 no long position is taken. To keep things simple the next possible day to open a long Vix position is the following month, if it is above 50 then again no position is taken and the hedge is put on hold for another month.

It is clearly visible that when the stock market has a positive performance the long Vix positions generate small profits or losses. However in the 2008 crisis when a portfolio of $100k mimicking the S&P 500 would have ended the year down by $37k, while the long Vix hedge would have generated $18,640. That's a reduction of more than 50%. Looking at the No Long Above 50 strategy we see it would have generated revenue of $38,530 more than completely offsetting the negative drawdown

Adding overall revenue for each strategy over the 12 year period the Always Long strategy generated $7,070 of profit and the No Long Above 50 strategy generated $26,960. There can be a lot to argue as to how often this type of hedge should be implemented, or as to how effective it would be when taking into consideration the effect of the futures term structure. However it seems to me there are strong indications that in the long run being long Vix futures may help protect your long only portfolio from the large drawdowns in times of market stress. At the same time it does not seem to impact negatively in times of positive returns for the broad stock market.

Disclosure: I/we 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.