Using VIX Options to Hedge Market Risk
Steve Papale

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).

Figure 1
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.

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