Hedging with the VIX

by Wayne Ferbert on October 7th, 2011

It stands to reason that if volatility increases when markets go down, then being long volatility would help offset some of that market loss. But is that actually the case?

As a long-term investor, these wild swings in the market don’t take quite the toll on me that they take on traders that are trying to predict these swings. I am invested for the long haul – so intraday movements don’t concern me that much.

However, wild price swings fuel the fear and paranoia in the market and, as a result, generally feed the bear market more than they feed a bull market. Bear markets do concern me. As a long-term investor, I am more often long the market than short the market.

These wild swings are called market volatility. Every market decline greater than 10% in the last 20 years has been characterized by higher market volatility.

Volatility can be measured. And since it can be measured, Wall Street has built investment mechanisms that are indexed to it. The most popular investment vehicle is the CBOE Volatility Index (^VIX). You can purchase or sell calls and puts on this index for many strike prices from one month to six months from today.

So, if volatility tends to feed and/or be a characteristic of a bear market, can we use that knowledge to build a hedge for our portfolio? It stands to reason that if volatility increases when markets go down, then being long volatility would help offset some of that market loss.

The VIX is a very liquid, high-volume options market on volatility so we can test this hypothesis. At my firm, we decided to run some back-tests and see if investing in volatility would have acted as a successful hedge against the market declines since 2008.

For the long-term investor, looking backward, the results were mixed at best. And looking forward, it looks like the long-term investor should avoid using the VIX as a hedge.

Our back tests definitely showed very good results for using the VIX as a hedge in late 2008 and early 2009. In fact, if you had set aside 7% of your portfolio in 2008 for routine purchases of at-the-money calls in the VIX, your market-indexed portfolio would have only declined by about 10% versus the wider market decline that year of greater than 35%. If you set aside 10% of your portfolio for these calls instead, you actually would not have lost money at all in 2008. Quite a feat really.

If you kept the routine purchase of at-the-money calls in the VIX going in to early 2009, you would have had a very large profit on the January VIX calls. On the 7% program, you would have been close to break-even. On the 10% program, your overall market-indexed portfolio would have made a profit. And if you regularly re-invested your profits from the VIX in to broad market index, you would have held 40% more shares at the end of 2009 than you started with in 2008. Imagine all of those extra shares poised for the rebound that followed the market collapse of late 2008 /early 2009.

The success of the VIX calls ahead of the market collapse of late ‘08/early ’09 should not surprise the reader. The market could not have forecasted such a dramatic drop in market prices. As a result, the price of the at-the-money VIX calls were quite a bargain, in retrospect. The collapse in market prices was historic in size and velocity – on par with the collapse of 1929, really.

Many of the VIX calls were bought at strikes around $20 or $30 and the VIX eventually traded in the $50s, $60s, and $70s. So, if you were in a regular VIX call purchase strategy going in to that collapse, you made out quite well. But what has happened since then?

The at-the-money calls you would have purchased with your portfolio would not have had much success since February ’09. In fact, every at-the-money call bought four months ahead of expiration that expired between February 2009 and April 2010 would have expired worthless. The next four months of May, June, July, and August 2010 would have produced small gains in the VIX calls but the total gain would have been less than 1% of the portfolio. Not enough to really offset any losses in a material way.

The next 12 months would have continued to see no gains in the expiring VIX calls that were bought at-the-money only four months prior. Only the recent increase in volatility that came with the August market swoon would have produced any gains in the VIX calls. And those gains would again be modest – around 1-2% of your portfolio value.

The recent market volatility has not let up. The regular and routine program in your portfolio that is purchasing VIX calls may still pay off. However, the signs don’t point to a big payoff in the recent round of purchases. The reasons are actually rather ironic.

The reason that the VIX calls are not paying off very well in the recent increase in the VIX index is that the Implied Volatility of the VIX calls has increased significantly. In other words, the price of the VIX calls has increased significantly – which is a reflection of the implied volatility of the VIX itself. Ironic. The VIX is a statistical measure of the volatility of the broad market. But the prices to buy/sell the VIX calls and puts has increased by a lot.

We can hypothesize on why these prices are being driven up so high. These implied volatilities on the call/put prices are significantly higher than the call/put prices back in 2008 and 2009 when the VIX was trading at similar levels. Let’s remember that these VIX calls are derivatives on an index. And that index is derived based on a calculation of prices and the dispersion of those prices. It is like a derivative of a derivative.

The people trading it are driving its price up. Ultimately, that is probably the most important point about the VIX. Many people trade in it. Very few invest in it. As a trading vehicle, the regular speculation in the VIX calls/puts creates a lot of price movement. The VIX trade paid off big in the ‘08/’09 collapse. So, buyers of VIX calls in these uncertain times are being forced to pay up for the chance to repeat history and get that lottery ticket again.

The result: the VIX doesn’t work today for the long-term investor looking to build an alternative hedge for his long market position. The fact that it worked so well in 2008 is irrelevant. That was like winning with a lottery ticket. Leave the VIX to the short-term traders looking for that short-term lottery ticket.

The buy-and-hedge investor that wants to hedge his positions needs to look to the traditional options market on the underlying investments in his portfolio. Nothing sexy – just collars, married puts, and spreads.

Posted in not categorized    Tagged with no tags


Leave a Comment