As of intraday Wednesday, shares of the iPath S&P 500 Short Term VIX Futures ETN (NYSEARCA:VXX) were down about 9.7%, as the stock market rallied on news of a Senate deal on a government debt limit extension. Recall that we posted a way to hedge VXX last week ("Getting Paid To Limit Your Downside On VXX"). In this post we'll look at how that hedge has reacted to Wednesday's drop so far.
Our October 9th VXX Hedge
This was the optimal collar*, as of October 9th's close, designed to limit an investor's losses to 20% over the next several months, for an investor willing to cap his upside at 20% over the same time frame:
As you can see at the bottom of the screen capture above, the net cost of that optimal collar was negative, meaning the investor would have gotten paid $360 to hedge.
How That Hedge Has Reacted To VXX's Drop
Here is an updated quote on the put leg as of intraday Wednesday:
And here is an updated quote on the call leg:
How That Hedge Protected Against Wednesday's Drop
VXX closed at $16.94 on Wednesday. A shareholder who owned 500 shares of it and opened the collar above on October 9th had $8,470 in VXX shares plus an outlay of -$360 on the hedge, so $8,110 taking into account the hedge.
VXX traded at $14.04 intraday Wednesday, October 16th, down 17% from its price on October 9th. The investor's shares were worth $7,020 as of intraday Wednesday, his put options were worth $965, and if he wanted to close out the short call leg of his collar, it would cost him $550. So: ($7,020 + $965) - $550 = $7,435. $7,435 represents a 8.3% drop from $8,110.
More Protection Than Promised
So, although VXX had dropped by 17% at the time of the calculations above, and the investor's hedge was designed to limit him to a loss of no more than 20%, he was actually down only 8.3% on his combined hedge + underlying stock position by this point.
Options Give You Options
Being hedged gives an investor breathing room to decide what his best course of action is. A VXX long hedged with this collar could exit his position with an 8.3% loss now (instead of a 17% loss), he could wait to see what happens, or if he remains bullish on VXX, he could buy-to-close the call leg of this collar, to eliminate his upside cap. If he's even more bullish, he could sell his appreciated puts, and use those proceeds to buy more VXX. He has those options because he's hedged.
*Optimal collars are the ones that will give you the level of protection you want at the lowest net cost, while not limiting your potential upside by more than you specify. Portfolio Armor's algorithm to scan for optimal collars was developed in conjunction with a post-doctoral fellow in the financial engineering department at Princeton University. The screen captures above come from the Portfolio Armor iOS app.