Use VIX To Hedge Your Equity Exposure

Includes: VIXM, VIXY
by: Labutes IR

The stock market has become much more volatile over the last few years, more specifically since the financial crisis of 2007-08. The negative tail risk, which is the risk of extreme negative returns, has become much more likely due to events like the European sovereign debt crisis, the Arab Spring or the potential U.S. fiscal cliff. The risk of huge losses is nowadays one of the investors' major concerns, leading over the last few years to a headline-driven market.

Instead of fundamentals, such as economic or earnings growth, the markets seem to respond more to general news, with the risk-on/risk-off environment driving valuations and leading to an increase in volatility. Since the summer of 2007, the implied volatility on the S&P 500, measured by the VIX Index, has averaged more than 25%. Over the previous five years, the VIX Index averaged only 17.5%, which represents almost a 50% increase.

(Click to enlarge)

Source: YahooFinance

However, compared to its recent history, the VIX index has decreased to very low levels over the last few months, mainly due to central banks' liquidity injections, namely Fed's QE3 and ECB's bond buying plan. Despite this, the general outlook for equity markets is broadly negative with investors worried about corporate profits, the U.S. presidential election, Europe's debt crisis and an imminent Spanish bailout, and a possible hard landing in China.

This bleak big picture doesn't seem to support the current complacent level of the VIX index. Additionally, the U.S. equity markets are trading near their highest levels since 2007 and the recent correction may continue for a few more weeks. Given the general negative relationship between returns and volatility in equity markets, investors should hedge some of their long exposure through VIX ETF's, like the ProShares VIX Short-Term Futures (NYSEARCA:VIXY) or ProShares VIX Mid-Term Futures (NYSEARCA:VIXM).

Alternatively, investors can sell their stocks and increase the cash component of their portfolios but adding these VIX ETFs one could hedge, to a certain extent, the market exposure and maintain the specific stock risk. With the earnings season picking up its pace, this is especially relevant for investors in Citigroup (NYSE:C), Goldman Sachs (NYSE:GS), Bank of New York Mellon (NYSE:BK), Bank of America (NYSE:BAC), Morgan Stanley (NYSE:MS), Google (NASDAQ:GOOG), General Electric (NYSE:GE), and Nokia (NYSE:NOK) that report earnings this week.

Disclosure: I 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.