VIX Options as Portfolio Insurance

As I type this, Congress is still debating the Troubled Asset Relief Plan (TARP) and various modifications and alternatives that have sprung up over the course of the past week.

While the outcome is uncertain, there is clearly a broad recognition that even a flawed plan  may be better than the possibility of the panic and chaos we could see in global financial markets on Monday if Congress is still trying to agree on a course of action.

If there is no agreement on a bailout by then, VIX options might be one potential source of catastrophe insurance for your portfolio. Before I go any further, let me quickly add that VIX options are such a strange and difficult to understand animal that SPY or SPX puts is probably a simpler and better way for most investors to find catastrophe insurance on the S&P 500 index.

With that caveat out of the way, consider that the VIX is now at about 36. It is important to understand that VIX options are not priced off of the cash/spot VIX currently at 36, but rather are priced off of VIX futures. This is an important distinction, as VIX futures for the month of October are in the 28s, the Novembers are trading in the 26s, and the December futures are trading in the 25s. For anyone looking to trade September VIX options, the underlying to focus on is October VIX futures, which is why the September VIX 20 calls are currently quoted at 8.80 – 9.10.

The second important factor to consider is that VIX futures move in a much more sluggish fashion than the cash/spot VIX index. For some supporting graphics to better illustrate how futures move vs. the VIX, try VIX Futures and Recent Market Action and VIX Futures: The One Picture to Remember. A rule of thumb is that VIX front month options generally move about half as quickly as the VIX.

If any of these thoughts about VIX options are new to you, then this is not the time to take a flier on VIX options. On the other hand, if you have an understanding on how these products work, it might be a good time to think about the VIX as portfolio insurance.

Comments

[Tom Armistead:]

With volatility as high as it is I don't see any point in attempting to hedge with VIX options. Just as soon as things calm down they will be worth half what you paid for them.

Last year when the VIX was moving in a range from as low as 9 to 18 or so, I hedged my portfolio using long term out of the money puts on the OEX (S&P 100 Index). I used a strike that was approximately 10% under the market and rolled the position upward every 20 points.

I expected to lose about 2% of my portfolio on this procedure and regarded it as an insurance premium. I cashed in large profits in January this year as the market bottomed. I noticed that the position responded favorably to volatility and sold as the VIX went over 30.

I haven't attempted any such hedges since because volatility has stayed high and the market is down. The time to establish a hedge is when everything is going very smoothly.

2008 Sep 26 06:38 PM

[rayman:]

Good post, there is also come good info on CBOE's site.
I think things will get better (like to be not completely bearish), currently I'm cost averaging into VXN puts, but you can options strategies just like any other asset (calendar spreads, etc.).

2008 Sep 26 07:50 PM

[fatcat:]

Good post,good comments...this is what Alpha is all about...

2008 Sep 26 08:05 PM

[andyn:]

What's the symbol for VIX options?
I cant find it on ETrade to purchase options on it.

2008 Sep 27 08:49 AM

[WEBISKING:]

All this money on the"sidelines" that is in either cash or commodities or coal and ag names will EVENTUALLY be deployed into HIGH QUALITY common stocks. Real estate Bubble of 2001-2006 has still not"recovered".In 1982 I locked in a 5 year CD at 17 % ,todaythat same CD will yield less than 4%. FUND managers DO NOT GET PAID to be in CASH ALL YEAR. Find companies like PM XOM and others with a Reasonably priced PE ,have a ROE average of at least 18% annually over the last 5 years and are worth over 100 billion dollars in market cap and can"absorb" large investments by the"big boys"

2008 Sep 27 09:39 AM

[Tom Armistead:]

VIX at 46, your hedging idea looks better to me today if you did it last week

2008 Sep 29 03:07 PM

[CPST1:]

Nice call.

2008 Sep 29 03:33 PM