When the VIX is low, the negative correlation of the highly volatile VIX to the S&P 500 index makes it possible to use VIX options as a hedge to protect a portfolio against a market crash.
To implement such a hedge, the investor buys near-term slightly out-of-the-money VIX calls while simultaneously, to reduce the total cost of the hedge, sells slightly out-of-the-money VIX puts of the same expiration month. This strategy is also known as the reverse collar.
The idea behind this strategy is that, in the event of a stock market decline, it is very likely that the VIX will spike high enough so that the VIX call options gain sufficient value to offset the losses in the portfolio.
To hedge a portfolio with VIX options, the portfolio must be highly correlated to the S&P 500 index with a beta close to 1.0.
The tricky part is in determining how many VIX calls we need to purchase to protect the portfolio. A simplified example is provided below to show how it is done.
A fund manager oversees a well diversified portfolio consisting of thirty large cap U.S. stocks. For the past two months, the market has been climbing steadily with the S&P 500 index climbing from 1273 in mid-March to 1426 in mid-May. At the same time, the VIX has been drifting downwards gradually, hitting a five month low of 16.30 on 17th May. The fund manager thinks that the market is getting too complacent and a correction is imminent. He decides to hedge his holdings by purchasing slightly out-of-the-money VIX calls expiring in one month's time. Simultaneously, he sells an equal number of out-of-the-money puts to reduce the cost of implementing the hedge.
As of 17th May,
According to the CBOE Website, on average, the VIX rise 16.8% on days when the S&P 500 index drops 3% or more. This means that if the SPX move down by 10%, the VIX can potentially shoot up by 56%. To play it safe, the fund manager assumes that the VIX will rise by only 40% when the SPX drops by 10%. This means that, in theory, the VIX should rise from 16.3 to 22.8 if the S&P 500 drops 10% from the current level of 1423 to 1280.
|S&P 500 Index||VIX||Call Options Value||Put Options Value||Net Premium Received||Unhedged Portfolio||Hedged Portfolio|
** - Based on historical data, the VIX does not stay below 10 and we assume the same for this example.
As can be seen from the table above, should the market retreat, as represented by the declining S&P 500 index, the negatively correlated VIX move upwards at a much faster rate. The VIX puts sold short will expire worthless while the value of the VIX call options rise to offset the loss of value in the portfolio.
Conversely, should the market appreciate, the rise in his holding's value is offset by the rise in the value of the VIX put options sold short. Notably, because the VIX has traditionally never gone below 10 for long, the put options sold short should not appreciate too much to cause significant damage to the portfolio. Hence, it is more favorable to implement this hedging strategy when the VIX is low.
In the event that the VIX spiked sharply (not impossible, given that the trading range of the VIX is 10 to 50), the rise in value of the VIX calls can even exceed the losses taken by the portfolio, resulting in a net overall gain.
Note: For the above example, transaction costs are not included in the calculations. Additionally, the following assumptions are made:
Unless very near expiration, VIX option prices reflect the forward VIX rather than the spot VIX. To discover the forward VIX, one can refer to the VIX futures price.
Historically, the VIX only move opposite the SPX 88% of the time. So this means there is still a 12% chance that the negative correlation will not materialise. So, unlike hedging with index puts, the protection is not 100% guaranteed.
Your new trading account is immediately funded with $5,000 of virtual money which you can use to test out your trading strategies using OptionHouse's virtual trading platform without risking hard-earned money.
Once you start trading for real, your first 100 trades will be commission-free! (Make sure you click thru the link below and quote the promo code '60FREE' during sign-up)Click here to open a trading account at OptionsHouse.com now!
Buying straddles is a great way to play earnings. Many a times, stock price gap up or down following the quarterly earnings report but often, the direction of the movement can be unpredictable. For instance, a sell off can occur even though the earnings report is good if investors had expected great results....[Read on...]
If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount....[Read on...]
If you are investing the Peter Lynch style, trying to predict the next multi-bagger, then you would want to find out more about LEAPS® and why I consider them to be a great option for investing in the next Microsoft®.... [Read on...]
Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date....[Read on...]
As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative....[Read on...]
Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date....[Read on...]
To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin....[Read on...]
Day trading options can be a successful, profitable strategy but there are a couple of things you need to know before you use start using options for day trading.... [Read on...]
Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator.... [Read on...]
Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa.... [Read on...]
In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as "the greeks".... [Read on...]
Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow.... [Read on...]