Using VIX Options to Hedge Market Risk
With the recent market volatility, one indicator that has gotten a lot of attention is the CBOE Volatility Index or VIX for short. The VIX is often described as the "fear index" because it tends respond to investor sentiment regarding the market. The calculation of the VIX is based on the markets expectation of 30 day volatility in the S&P 500 Index using the implied volatility of the cash-settled SPX options traded at the CBOE.
As perceived risk in the stock market rises, investors tend to purchase more options, particularly puts, for protection against a market decline. This greater demand for options causes implied volatilities to go up. As implied volatility rises, so does the VIX. Conversely, as investors perceive markets to be less risky, the demand for protective options goes down, lowering implied volatility. The lower implied volatilities are reflected as a decline in the VIX.
Since the VIX typically rises as investors market fears increase, there is generally an inverse correlation between price movement in the VIX and price movement in the S&P 500. So as the stock market falls, the VIX rises and vice versa. This can be shown graphically below (using the SPY as a proxy for the stock market).
Figure1. Overlay of Price Charts for the Past Year: SPY vs. the VIX
Notice that each time the VIX reached a level over 30 the SPY tended to find a market bottom. This level of 30 or greater thus equates to a high level of nervousness and pessimism in many market participants, which may be used as a bullish contrary indicator. Conversely a relatively low VIX reading below 20 may signal complacency in the market, signaling a bearish contrarian signal.
One should be careful to note that over time the VIX levels that some might signal as market tops or bottoms can change. During the second half of 2006 into early 2007 the VIX gradually declined until it bottomed out around 10 and topped out at around 13. The market selloff that occurred on 2/27/2007 signaled the start of a higher trading level for the VIX that continues through to today.
Can an investor who is generally long a portfolio of stocks use the negative correlation of the VIX to protect against a loss from a market decline? One strategy might be to buy a call or a call spread on the VIX. So in a downward moving market when our portfolio might be losing money, the VIX should be increasing in value causing our call spread to increase in value as well, at least partially offsetting our losses in the stock market.
One interesting characteristic of the VIX is that the prices are not lognormally distributed as they are in stocks and stock indexes. Lognormal distribution means that the price is just as likely to double as to drop in half. If the VIX were to go to 0 this would imply no expected change in daily value of the SPX. Conversely, if VIX were to reach an extremely high value and persist that would indicate that the market expected extremely large price movements for an extended period of time.
But the VIX tends to stay in a range roughly between 10 and 35. This characteristic is known as mean reversion. Mean reversion is a tendency near, or tend to return over time to a long-run average value. Interest rates and implied volatilities tend to exhibit mean reversion, while exchange rates and stock prices do not.
This information is very useful to know when trying to decide the most advantageous time to place a trade in the VIX. For example, if the VIX is extremely low and we want to hedge against a downward move in the stock market, we may decide to put on a bullish position in the VIX instead of a more traditional hedge like a bearish position in an index.
The reason a trade in the VIX may be more advantageous is that if the market does fall, both the VIX call spread and SPY put spread should perform well. However, if you are wrong and the market rallies, you know for certain that the SPY put spread will lose a lot of money. The VIX index, however, may not fall significantly since it is already at an extremely low level.
Let's compare how a VIX call spread and a SPY put spread would perform during a market selloff using specific trades. At the market close on Friday February 23, 2007 the S&P 500 Depository Receipts (Symbol: SPY) was at 145.31 and the CBOE Volatility index (Symbol: VIX) was at 10.58.
At the time you could have purchased an April 143-141 bear put spread on the SPY for $0.50, or a total cost of $50. At that same time, you could have also purchased the April 12-14 bull call spread on the VIX for a net debit of $0.50, or the same total cost of $50. The April options had 57 days of life remaining until expiration at this time.
By the close on Tuesday, February 27 2007 the market had dropped substantially and the SPY was trading at a price of 139.85, a decline of 3.75%. We then closed both trades. The following table shows the performance of both trades over this period of time.
||Opening Trade Description
||Closing Trade Description
||Buy 1 April 143 put @ $1.35
Sell 1 April 141 put @ $0.95
For Net Debit of $40
|Sell 1 April 143 put @ $4.80
Buy 1 April 141 put @ $3.70
For Net Credit $110
||Buy 1 April 12 call @ $1.55
Sell 1 April 14 call @ $1.05
For Net Debit of $50
|Sell 1 April 12 call @ $3.10
Buy 1 April 14 call @ $1.70
For Net Credit $140
So the SPY put spread was sold for a net credit of $110, a gain of $70 or 175 percent. During this same time period, the VIX moved up to 18.22 (an increase of 72.2%) and the VIX call spread was sold for a net credit of $140, a gain of $90 or 180 percent. Notice that while the price of the VIX increased much more on a percentage basis than the SPY dropped in price, we realized nearly the same return on both trades (175% vs. 180%).
Why would they have nearly the same return when the VIX call spread was much more in the money (on a percentage basis) than the SPY put spread? Because the VIX is mean reverting. The market expects the much higher level in the VIX to be a short term event and things to return to more "normal" levels in a relatively short period of time.
So we have seen that a bearish position in the SPY and a bullish position in the VIX perform equally well as a hedge in a declining market. Trying to keep conditions as close as possible to the previous example, we will again use specific trades to compare how those two hedges would perform if instead the stock market were to go up. Looking at a price chart of the SPY, a move up of nearly the same magnitude occurred just a couple weeks later between March 16, 2007 and March 21, 2007.
At the close on March 16, the SPY was trading at 138.53 and you could have purchased a May 136-134 bear put spread for a net debit of $0.55, or a total cost of $55. The VIX was trading at 16.79 and you could have purchased the May 18-20 bull call spread for a net debit of $0.40, for a total cost of $40. The May options at this time had 64 days of life remaining until expiration.
By the close on March 21 the market had moved up and the SPY was now trading at 143.29, an increase of 3.44% from when the trades were originally placed. We then closed both trades using the closing prices of March 21, 2007. The following table shows the performance of both trades over this period of time.
||Opening Trade Description
||Closing Trade Description
||Buy 1 May 136 put @ $2.30
Sell 1 May 134 put @ $1.75
For Net Debit of $55
|Sell 1 May 136 put @ $0.70
Buy 1 may 134 put @ $0.65
For Net Credit $5
||Buy 1 May 18 call @ $1.00
Sell 1 May 20 call @ $0.60
For Net Debit of $40
|Sell 1 May 18 call @ $0.60
Buy 1 May 20 call @ $0.45
For Net Credit $15
So the SPY put spread could be sold back for a net credit of only $5 resulting in a loss of $50, or 91 percent. During this same time period, the VIX down to 12.19 (a decrease of 27.4%) and the VIX call spread was able to be sold for a net credit of $15, a loss of $25 or 63 percent. While both hedges performed similarly when the market dropped in value, the VIX hedge lost less than the traditional hedge in an index when the market rose.
The VIX is often discussed as a sentiment indicator, but the availability of trading in VIX futures and options now allow you to add it to your trading toolbox. The VIX options can be used to speculate on expected moves in the stock market, or as a hedge to offset market risk. The difference between how the VIX and other equity indexes react to price changes in the market make it worth taking the time to learn how to use the VIX as a risk management and trading tool.