Using VIX Hedges to Reduce Strike Dependence

Equity investors who want a broad-based hedge have essentially three vehicles from which to choose: equity index options (SPY, SPX, ES, etc.), VIX futures (or their ETF permutations), and VIX options. In this piece, Larry McMillan makes the case for using VIX options instead of SPX derivatives, and this is his best argument:

In my opinion, the purchase of VIX calls is a much better, more dynamic way, to approach protection. That is because VIX will explode whenever the market declines sharply, no matter where the S&P 500 is. But if you buy SPX puts today and then a large rally ensues before a large decline occurs, the striking price of your SPX puts is likely to be so far out of the money as to do you no good during the declining phase.

Call this the problem of strike dependence. If you enter a one-year at-the-money SPX hedge today using a striking price of 1040, the puts you bought won’t do you much good if the market recovers this year and then slips dramatically next spring from much higher levels. Using a strike-dependent price-based hedge, it is entirely possible to lose money on both the hedge and the core portfolio if the hedged asset(s) don’t follow a favorable path over the life of the hedge. By contrast, the February 2011 VIX futures (currently the furthest-dated listed contract) will be profitable at expiration if the VIX is anywhere above $33.80.  The big advantage of volatility-based products is that they are linked not to some absolute price level, but to an absolute volatility level: the VIX futures will hedge against implied volatility above roughly 34% no matter whether that volatility occurs with the S&P 500 at 1040, 1240, or 440.

In my experience, many equity investors are more concerned anyway about hedging against volatility than about protecting against declines below some specific price level. Gradual, orderly bear markets can be managed as easily as steady bull markets; it’s the sudden shocks that concern people.

I’m not as favorably inclined toward VIX options as McMillan seems here. For one thing, outright VIX option buyers seem to be paying for their optionality two times over: VIX futures already have option-like properties in that they tend to carry a premium to current IV levels, especially in further months. That premium “decays” as a given contract nears expiration, such that a “buy and hold” VIX futures trader isn’t gaining long exposure to volatility explosions for free: most of the time, she is paying each month for the privilege of watching volatility not explode. That volatility risk premium is not so large that hedging becomes prohibitive – not at all – but in my opinion the added costs of VIX options are only worthwhile if those option hedges are actively and carefully managed.

That last point suggests the rejoinder available to any proponent of conventional equity index hedges: strike dependence is only a major problem for investors who insist on passive, long-dated hedges. An investor who is willing to roll their option hedges more frequently can avoid the problem of strike dependence and therefore can trade the more easily understood S&P 500 products. My own order of preference for hedging an equity portfolio runs: VIX futures, SPX/ES options, and then VIX options.

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7 Comments For This Post

  1. Jacob Says:

    What do you think of in the money VIX options that have little or no time value? Would that be a suitable substitute for VIX futures or VXX shares?

  2. Jared Says:

    I don’t have a strong opinion, and I expect they’d track the underlying just as well as any other 1.00 delta option. The bid/ask spreads on ITM VIX calls look about 0.40 – 0.50 wide, fwiw.

  3. Chris Says:

    You took the words right out of my mouth – again.

  4. scrilla_gorilla Says:

    VIX futures essentially suffer from the opposite problem though. VIX will spike temporarily on any sharp declines, but the market then becomes desensitized and (over the long-term) VIX can decline even as the market declines. For example, let’s say the SPY is trading @ 104, and it proceeds to decline to 75 over a period of 12 months. Even though the VIX will undoubtedly spike at certain times, its long-term average may only move marginally higher. So you could have a situation where the market has lost 30% but at expiration the VIX is still below your strike price.

  5. VT Says:

    There is a huge problem with using May 2011 VIX options as you have in your example. If the market crashed tomorrow, the VIX may spike to 80, but the may 2011 vix futures (which your options expire into) would probably only rally a tiny fraction of that. The reason for this is that vol is mean reverting. By your 2011 expiration, the VIX could be all the way back down to 30 or lower. Back month vol does not respond much to current shocks.

  6. VT Says:

    Not sure why I said May. You used Feb in your example. The idea is still the same. sorry

  7. Jared Says:

    scrilla: That’s a good point, and I think the lesson is that hedging strategies will be more effective if they’re shorter-term and/or more active.

    VT: I didn’t use a VIX options example, but in any case there was a sizable move in the back-month futures during the crash of 2008 – large enough that both futures and options buyers saw substantial gains. The mean reversion effect you mention is exactly right, but I would only see that as a problem for someone who was (naively) expecting the tradable products to precisely track the spot index.

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Jared Woodard specializes in trading volatility as an asset class. With over a decade of experience trading options and other volatility products ... Read More


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