Using VIX Options for Protection

03/13/2012 2:00 pm EST

Focus: OPTIONS

James Bittman

Senior Instructor, Chicago Board Options Exchange

Traders and even longer-term investors can use VIX options as a relatively inexpensive insurance policy on their open positions, explains CBOE options instructor Jim Bittman.

How do you use VIX options to protect a portfolio? Our guest today is Jim Bittman to talk about that.

Jim, let’s first talk about how you use VIX options to protect an overall portfolio.

Well, people who watch the Volatility Index (VIX) should be aware that when the market goes down, VIX tends to go up. The logical portfolio protection strategy is to buy call options on VIX.

When VIX is low, there does not appear to be a disaster on the horizon. It’s kind of like how you buy an insurance policy on your car not when you’re sliding into the brick wall, but when you’re home and the car is parked in the garage and there is no danger in sight.

When VIX is low, that implies there’s a lot of complacency in the market. Nobody expects anything bad to happen, but as we all know, the market has downdrafts. News comes out of nowhere; economic reports; developments from Europe; any number of things can cause the market to go down.

If you have some VIX options in your portfolio, then when the market has this unexpected downdraft and volatility—through the VIX index—shoots up, then your call options will be in place to benefit.

People who do this on a regular basis have said that it is cheaper to buy VIX options on a consistent basis. When they expire worthless, that’s a cost, but that cost is lower than buying index put options on a portfolio.

When you say VIX is low, give us a number or context for what that means.

Well, you know, this is all subject to judgment, but typically, a low VIX is below 20%. In some market environments, it can be below 15%, but that’s generally considered to be low.

A VIX above 30% is generally considered to be high. Now VIX can go to 40% or 50%, and it has been much higher, but typically, those are the ranges that people talk about.

Jim, what do you suggest in terms of how far out I should buy these call options?

Well, VIX has a tendency to spike dramatically in a very short period of time when an unexpected market disruption occurs.

Believe it or not, people are buying out-of-the-money VIX calls with a month to go. They typically buy them five weeks in advance of the VIX expiration. You actually have two options for a week, but then you’ve got five weeks of protection overlapping a week, and then four more weeks. The last week is overlapped before you have four more weeks.

If this unexpected event were to happen in that last week, then you would have double protection, which would be fantastic, but you can’t predict these things, of course, so the vast majority of time, you would have one unit of protection and that’s the way it would work.

Alright, and then finally, on a hypothetical $100,000 portfolio, how much should I buy? Should I buy enough to protect the entire portfolio, a portion of it; what do you suggest there?

Believe it or not, as simple as that question sounds, it is a very, very difficult question to answer.

Basically, if you believe that your $100,000 portfolio might decline 10%, or a $10,000 loss, then you would buy ten VIX options, and if VIX were to go ten points above your strike price—which is a very reasonable expectation—then each of those options would be worth $10,000 and largely offset your portfolio decline.

There’s a lot of guesses in that method, like by how much money might your portfolio decline, and how high might VIX go, but these are the decisions that have to be made; there’s no formula that tells you. It’s not like I have a $100,000 house, so I buy a $100,000 policy; it is a different concept.

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