Using VIX Options to Hedge Your Portfolio

Introduction

Several investors expressed interest in trading instruments related to the market's expectation of future volatility, and so VIX futures were introduced in 2004, and VIX options were introduced in 2006.

Options and futures on volatility indexes are available for investors who wish to explore the use of instruments that might have the potential to diversify portfolios in times of market stress.

VIX is a great way to hedge your long portfolio. It is a well known fact that during severe market downturns, VIX spikes significantly, which can offset some of your portfolio losses. However, you cannot trade VIX directly. There are few ways to trade VIX:

• ETFs/ETNs. iPath S&P 500 VIX Short-Term Futures ETN(NYSE:VXX) is just one example. VXX trades first and second month VIX futures. Unfortunately, VXX is not designed to be held beyond very short period of time due to contago loss. Most days both sets of VIX futures that VXX tracks drift lower relative to the VIX—dragging down VXX’s value at the average rate of 4% per month (30% per year). In fact, VXX is probably one of the worst long term investments.
• VIX futures and Options. Options and futures are investments with a definite lifespan; not only do investors have to be right about the direction of volatility, but also the timeframe.

Of course if you buy VIX calls and volatility spikes, you can make some significant gains. But most of the time, those calls will lose money due to the fact that VIX drift lower, and those options will lose value over time.

Possible solution: VIX strangle

This article describes the following strategy of going long VIX:

1. Purchase VIX put options that expire 3 months out and are 2.5% out of the money and simultaneously buy 4th month call options that are 20% out of the money.  These positions are established each month on a date that is half way between the 3rd and 4th month expiration dates. Two months later these option positions are rolled. 
2. The put leg of the calendar strangle can help reduce the cost of the long call.  Typically, when hedging through purchasing an out of the money call option on VIX to gain protection against tail risk there can be an undesirable carrying cost for the position.  In periods of low volatility the long put position will benefit from the term structure of VIX futures pricing as the time to expiration for the option approached expiration.  The long call position will be in place to potentially benefit from market conditions that result high higher implied volatility for the market as indicated by VIX.

The general idea is that short term futures are declining faster than long term futures, and if VIX stays stable, the put gains will offset the call losses. Basically the strategy will roll the trade every two months.

Expected results

During calm periods when VIX stays stable or drifts lower, we can expect the trade to produce 10-15% gains or end up around breakeven because the puts gains will offset or slightly outpace the calls losses.

However, during periods of volatility spike, the calls should gain significantly, and in some cases, the whole structure can deliver 50-100% gains. This is basically a cheap way to go long VIX and hedge your long portfolio, without experiencing losses during calm periods.

We have made several changes to the strategy in order to better adapt to the current market conditions.

Related articles:

• VIX - The Fear Index: The Basics
• VIX Term Structure
• Top 10 Things To Know About VIX Options

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