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Does Hedging Using VIX Options Work?

|Includes: SPDR S&P 500 Trust ETF (SPY)
Summary

Hedging SPY Portfolio Using VIX Options.

Backtesting VIX Bull Call Spreads to protect against market downturns.

Review of VIX Bull Call Spreads as a portfolio hedge.

Can an investor who owns a portfolio of stock use the VIX to protect against a loss from a market decline? One strategy might be to buy a call or a Bull call spread on the VIX. So when our portfolio loses money during a market downturn, the VIX should be increasing in value. This would cause our VIX Bull Call spread to increase in value to offset the losses from our stock portfolio.

What is VIX Bull Call Spread?

A "bull call spread" on the VIX entails buying one VIX call and selling a higher-strike, lower-priced VIX call to offset some of the premium cost. The bull call spread will profit from the VIX moving up and lose from the VIX moving down. The maximum gain and risk are known from the outset of the trade and therefore allow for very specific risk management.

Source: Options Industry Council

One caveat with trading VIX options is that the VIX options are priced off the VIX Futures and NOT the VIX index. Hence, the options prices may not track the VIX particularly well, especially for longer-dated options. However, the closer the VIX Future and the associated VIX options are to expiration, the closer they will track the VIX.

Our VIX Hedging Strategy:

Let's evaluate the performance of hedging using VIX call spreads. We will use the SPY as our benchmark portfolio, and evaluate the performance of hedging our SPY portfolio using VIX options.

Benchmark Strategy:

  • Buy and hold SPY

VIX Hedging Strategy:

  • Hedge our SPY holdings using Bull Call Spreads on the VIX with the following criteria:
  • 70 - 80 days to expiration
  • Out of the money by 15 - 20%
  • Exit our Bull Call Spread at expiration or when it makes 50% profit or greater.
  • Once prior spread is closed, open a new Bull Call Spread will same criteria as above

Although we can use a platform like Bloomberg to backtest our trading strategy, a better alternative is to evaluate our strategy using an options backtesting platform such as OptionStack. Let's review what our trading strategy looks like on the OptionStack platform:

VIX Bull Call Spread Trading Strategy

Source: OptionStack

Let's review the results of our backtest between 2014 - 2016:

Backtesting Performance Results

Source: OptionStack

The top chart reviews the profit / loss of our VIX hedging strategy. The middle chart compares the performance of our hedged portfolio (Yellow Line) versus the un-hedged portfolio (Green Line). The bottom chart displays the VIX closing prices (Blue Line).

As you can review from the results (middle chart), our VIX hedging strategy had periods of over-performance and under-performance. During market downturns where the VIX increased, our hedged portfolio significantly outperformed the benchmark portfolio. Conversely, in market rallies accompanied by declining VIX, our hedged portfolio slightly under-performed the benchmark. But for the majority of the time, our hedged portfolio (Yellow Line) outperformed our un-hedged benchmark portfolio (Green Line).

As a follow-up, you can optimize the strategy by adjusting any of the following:

  • adjust the strikes of the bull call spread (at-the money, further out-of-the-money, in-the-money, etc).
  • adjust the days to expiration (shorter term, longer term, etc..)
  • adjust the position size of the VIX bull call spreads
  • adjust the profit / loss targets
  • etc..

In summary, hedging our SPY portfolio using VIX Bull call Spread reduced the volatility of our portfolio and was an effective way to way to hedge our portfolio against stock market declines.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.