Your Guide to Hedging With the VIX

About a decade ago, I doubt many people had even heard of the VIX. I was an options market maker on the AMEX at the time and I’d heard of it, and we had it up on our screens but, truthfully, we never paid it the slightest bit of attention. We had our own local volatility, and we didn’t need an indexed version to tell us what we already knew.

But a decade is a long time. Some time around the turn of the millennium and the market ugliness that followed, the VIX got on everyone’s radar. Followed, of course, by the ability to actually trade the VIX in many different forms. And, yes, the whole concept of “volatility as an asset class” as portfolio protection, i.e., hedging with the VIX.

Learn 10 Things You Need to Know About the VIX.

The VIX trading industrial complex now allows us to trade futures on the VIX, options on VIX futures, mini-versions of VIX futures, and VIX ETNs based on hypothetical VIX futures. (Find out about the latest VIX product.) And then there are options on all of the above.

Long-term Hedging With the VIX

With such a wide array of choices, where do you even begin?

More importantly, does it pay to use them at all when there’s a simpler alternative to portfolio protection to begin with in the form of good, old put options on the S&P 500 Index (SPX) or SPDR S&P 500 (NYSE: SPY).

Personally, I like to keep it simple and use those SPX and SPY puts. But that might make me a VIX Luddite, because the new-fangled VIX family can outperform.

CXO Advisory recently summarized a study by Bernard Lee and Yueh-Neng Lin, titled “Using Volatility Instruments as Extreme Downside Hedges.” They looked at rolling SPX/SPY puts versus rolling VIX futures of differing time frames. And they came to the following conclusions:

“Rolling VIX and VT futures contracts are more cost-effective extreme downside hedges than rolling out-of-the-money S&P 500 Index put options. VIX futures are the most cost-effective choice for hedging extreme downside risk. And, rolling 3-month VIX futures contracts outperform rolling 1-month VIX futures contracts, indicating that the increased trading frictions of more frequent hedge adjustments outweigh incremental hedging value. Based on the relatively high liquidity of 3-month VIX futures contracts, real-life traders appear to have developed the correct market intuition.”

Jared Woodard of Condor Options looks at something similar: two-month rolling VIX futures versus the iPath S&P 500 VIX Short-Term Futures ETN (NYSE: VXX), which is based on a hypothetical 30-day VIX future, and produces this pretty stark graph dating back to the beginning of VXX trading at the end of January 2009.

Short-term VIX Hedging

For myriad reasons, not everyone can trade futures. Nor does anyone necessarily want to hedge for an extended length of time. Perhaps you fear a market meltdown in the next few weeks. If you expect something more imminent, you always want to go near in time, especially in VIX-land where VIX futures often don’t capture enough of the sudden bursts. So this leads us back to VXX, VXX calls, or near-term VIX calls.

VXX

While VXX proxies a constant rolling 30-day future, it does not do it particularly well as you can infer from the above graph. Between constant poor rolling into an upsloping futures curve, and the futures premium itself, VXX does poorly as a hold. But on a day-to-day basis, it more or less captures half the VIX move, so is perfectly fine to use as a short-term trade.

VXX Calls

Calls on VXX are perhaps the most numbing concept out there. It’s a derivative on an ETN (VXX) that proxies a hypothetical future on a statistic (VIX) that itself measures implied volatility of a derivative (SPX options) on an index (SPX). But you can easily simplify it. Upon exercise, you receive delivery of an ETN (VXX) that in the very short term will track about half the VIX move, so it’s a decent way to play for an imminent move if you expect one.

Short-term VIX Calls

Near-term VIX calls perform a similar function. Always keep in mind, though, that these are calls on the VIX future, not the VIX itself. The future almost always trades a premium to “cash” VIX, which adds to confusion when pricing these by the naked eye. In other words, “the money” is higher than you think just looking at the VIX. Also important to remember is that VIX options are European-style options, which means you can’t exercise them early. They also cash-settle, meaning if you hold until expiration, you get delivery of nothing. And, finally, skew in VIX products is huge. You will pay a much higher price (in volatility terms) as you go higher in strike. Keep in mind, though, that the skew curve is virtually always steep, so even if you pay up to begin with, the bid (in volatility terms) will still be high if/when you sell.

So to throw a bow on this thing, I’d re-emphasize that there are many ways to trade VIX products, it really just depends on your time frame. For longer-term portfolio hedging, stay away from VXX and go with two- or three-month VIX futures, and roll them (or just stick with and roll SPX/SPY puts if you prefer).

To trade or play short term, in general, VXX, VXX options and VIX options are the way to go.

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