Using the CBOE Market Volatility Index (VIX) to Hedge?

02/25/2009 10:59 am EST

Focus: STRATEGIES

Nick Perry

Equity Options Trader, Schaeffer's Investment Research

Last week on the Trading Floor Blog, I shared some internal comments about the CBOE Market Volatility Index (VIX). A discussion over the weekend between Bernie and Todd Salamone, our senior vice president of research, has since caught my eye and I wanted to share a snippet of that.

It was just over three years ago that listed options began trading on VIX. This led some to argue that you should buy VIX calls for portfolio protection instead of buying SPX puts. The key reason is that this helps you avoid a lot of the problems associated with timing a possible plunge. Here is how Bernie explains it:

"For example, if you buy six-month, 650-strike S&P 500 (SPX) puts with SPX at 775 and the SPX moves sideways for five months and then plunges to 650 in a few days, you make little, if any, money on this trade. There was a crash, but you end up with very little delta and very little time premium because of timing issues. But if you had bought VIX calls instead, you will (theoretically) get the volatility spike you need to make money if you get a market plunge over the next six months—the VIX will pop to 70 or 80 or 90 and you will profit (depending also, of course, on how the VIX futures trade relative to cash VIX)."

In theory, the VIX calls sound good, but Bernie notes we may be faced with a new phenomenon: the slow-bleed bear market in which volatility (though still high) actually recedes. The chart below shows the VIX plotted alongside the SPX.

chart

Even though the S&P 500 (SPX) is back to its lows, the VIX remains well off its highs. As Todd noted:

"Isn't this a nightmare for those buying VIX calls for portfolio protection? Are they really getting the protection they need? Could this spur more panic selling, or create an incentive to up the ante for more portfolio protection. If one was hedging against a move down to former lows of November via VIX options, my guess is he is not a happy camper."

By Nick Perry of Schaeffer’s Trading Floor Blog

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