Thursday, July 9, 2009

The VIX as a Hedging Tool

I generally use the VIX as a speculative vehicle rather than a hedging tool, but lately I have received several questions about how one might go about hedging a portfolio with the VIX. The subject of hedging is going to require a series of posts in order to do it justice, but before I dive in, I thought I should share an interesting paper from Edward Szado that recently became available on the web site of the Center for International Securities and Derivatives Markets (CISDM) at the University of Massachusetts.

In Szado’s own words, his paper “assesses the impact of a long VIX investment as a diversifier for a typical institutional investment portfolio during the 2008 credit crisis. The analysis covers the period of March 2006 to December 2008 (beginning shortly after the introduction of VIX options in February of 2006) with a focus on the latter part of 2008 (from August to the end of December).”

The research utilized by Szado incorporates three different long VIX hedging strategies.

  • VIX futures (near month, 2.5% and 10% allocations)
  • VIX at-the-money calls (1% and 3%)
  • VIX 25% out-of-the-money calls (1% and 3%)

The full text of Szado’s conclusion is as follows:

“Ultimately, the goal of this study is not to make a strategy recommendation for an ongoing risk management program, but rather to consider the impact that a long VIX exposure would have had in this particular time period. The increased correlations among diverse asset classes in the latter half of 2008 generated significant losses for many investors who had previously considered themselves well diversified. It is clear from the results of the analysis that, while long volatility exposure may result in negative returns in the long term, it may provide significant protection in downturns. In particular, investable VIX products could have been used to provide some much needed diversification during the crisis of 2008. In addition, the results of this study suggest that, dollar-for-dollar, VIX calls could have provided a more efficient means of diversification than provided by SPX puts.”

Going forward, I will discuss in more detail the approach and data from Szado’s study and offer some of my thoughts about using various VIX products for the purpose of hedging.

Further reading:

6 comments:

Tyler Craig said...

Really looking forward to a new series on this subject matter. Keep up the good work!

Tyler

www.tylerstrading.com

Artem Dmytrenko said...

hm... rather interesting.. we are making now market neutral strategy portfolio.. we see that our portfolio is feeling much better when volatility increasing.. so maybe we can make hedge from low volatility with vix? but than we will not be market neutral i guess.. *just random thoughts now..

Anonymous said...

"It is clear from the results of the analysis that, while long volatility exposure may result in negative returns in the long term, it may provide significant protection in downturns. "

Duh...do you really need a research paper to reach this conclusion? What a genius!

goldstocktrades said...

I'm looking to invest in the VXX as a way to protect from the next market downturn.

Deflation Crisis Part II

Mohka Canvas Art said...

That's awesome, thanks a lot for sharing this with us!

canvas art shop said...

Great post!

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