Portfolio Hedging using VIX Calls

VIX options can be used to express a volatility view or as part of a portfolio hedge. VIX often rises during equity stress, but its relationship with the S&P 500 is neither fixed nor guaranteed. The following historical example illustrates a proposed hedge and the assumptions on which it depends.

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 proposed offset relies on VIX calls gaining enough at the relevant horizon to compensate for portfolio losses. The size and timing of that gain cannot be inferred from the current spot VIX or from an average historical correlation.

Implementation

Hedge sizing depends on the actual portfolio and the response of the chosen VIX option series. A beta near one to the S&P 500 does not by itself determine the needed option quantity. The calculation below is a scenario, not a generally valid hedge ratio.

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.

Example

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,

• For simplicity's sake, let's assume the value of his holdings is $1,000,000.
• The S&P 500 Index stood at 1423.
• The VIX is at 16.30.
• June VIX calls, with a strike of 19 points, have a premium of 0.40 points each.
• June VIX puts, with a strike of 12.50 points, have a premium of 0.25 points each.

So, how many VIX calls does the fund manager need to buy to provide the necessary protection?

Assume, solely for this scenario, that a 10% portfolio decline coincides with an official VIX option settlement value of 22.80. The old article extrapolated a historical average daily VIX response linearly; that does not establish a reliable forecast or a conservative bound. The following list retains the original quantity and premium calculations, interpreted using that official settlement assumption.

• At an official final settlement of 22.80, each 19-strike call pays (22.80 − 19) × $100 = $380.
• 10% of the fund manager's portfolio is worth $100,000.
• Number of calls for $100,000 gross proceeds in this scenario: $100,000 ÷ $380 ≈ 263.16, rounded up to 264.
• Total cost of purchasing the 264 VIX June $19 calls at $0.40 each = 264 x $0.40 x $100 = $10,560
• Premium received for selling 264 June $12.50 VIX puts at $0.25 each = 264 x $0.25 x $100 = $6,600
• Total investment required to construct the hedge = $10,560 - $6,600 = $3,960

** The last row repeats 9.78 as an assumed settlement scenario. VIX has no contractual floor at 10, and historical ranges do not cap short-put losses.

Under the particular paired portfolio and VIX settlement scenarios in the table, the calls offset some or all of the portfolio decline and the puts expire worthless in the down-market rows. Different timing or volatility outcomes can leave the portfolio decline substantially unhedged.

In the up-market rows, a fall in VIX settlement below 12.50 creates a loss on the short puts that offsets some stock gains. There is no guarantee that stock gains accompany that short-put loss. With a nonnegative settlement floor, 264 puts at strike 12.50 can owe up to $330,000; including the $3,960 net option debit, the option package can lose $333,960 before costs.

A sufficiently large settlement value can make the calls’ gain exceed the portfolio loss in a particular scenario. VIX is not confined to a 10-to-50 range. A temporary spike that reverses before the relevant settlement or exit may provide much less protection.

Note: For the above example, transaction costs are not included in the calculations. Additionally, the following assumptions are made:

• Assumed matching portfolio return (not established by beta alone) between the portfolio and the S&P 500 index.
• The rise/fall of the market occurred on option expiration date.

Things to remember

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.

An observed historical percentage of opposite-direction moves is not the probability that this hedge succeeds. Index puts also require matching exposure, quantities, timing and settlement. Neither hedge guarantees protection for an unrelated portfolio.

Gross coverage versus net protection

The original 264-contract calculation rounds $100,000 ÷ $380 up to 264 and targets gross call proceeds. After the $3,960 debit, that scenario produces $96,360 of net option gain, leaving the hedged portfolio at $996,360. To offset a $100,000 loss after a $15-per-pair debit in this exact scenario would require rounding $100,000 ÷ ($380 − $15) up to 274 pairs. Neither quantity guarantees protection under another scenario.

All historical index levels, premiums and dates above are teaching inputs. The table assumes the stated portfolio return and official settlement outcome, excludes costs and ignores interim margin calls on the short puts. Current VIX options have contract-specific settlement and last-trading procedures; consult the current VIX guide.