Portfolio Hedging using VIX Calls

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.

Implementation

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.

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 price of $19, are priced at $0.40 each.
• June VIX puts, with a strike price of $12.50, are priced at $0.25 each.

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

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.

• When the VIX is at 22.8, each June $19 VIX call will be worth $380 ($3.80 x $100 contract multiplier).
• 10% of the fund manager's portfolio is worth $100,000.
• Number of VIX calls required to protect 10% of the portfolio is therefore: $100,000/$380 = 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

** - 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:

• Full correlation (beta of 1.0) 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.

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.

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