Friday, September 26, 2008

VIX Options as Catastrophe Insurance

As I type this, Congress is still debating the Troubled Asset Relief Plan (TARP) and various modifications and alternatives that have sprung up over the course of the past week.

While the outcome is uncertain, there is clearly a broad recognition that even a flawed plan announced before the markets close today may be better than the possibility of the panic and chaos we could see in global financial markets on Monday if Congress is still trying to agree on a course of action.

If there is no agreement on a bailout by the end of the day, VIX options might be one potential source of catastrophe insurance for your portfolio. Before I go any further, let me quickly add that VIX options are such a strange and difficult to understand animal that SPY or SPX puts is probably a simpler and better way for most investors to find catastrophe insurance on the S&P 500 index.

With that caveat out of the way, consider that the VIX now at about 36. It is important to understand that VIX options are not priced off of the cash/spot VIX currently at 36, but rather are priced off of VIX futures. This is an important distinction, as VIX futures for the month of October are in the 28s, the Novembers are trading in the 26s, and the December futures are trading in the 25s. For anyone looking to trade October VIX options, the underlying to focus on is October VIX futures, which is why the October VIX 20 calls are currently quoted at 8.80 – 9.10.

The second important factor to consider is that VIX futures move in a much more sluggish fashion than the cash/spot VIX index. For some supporting graphics to better illustrate how futures move vs. the VIX, try VIX Futures and Recent Market Action and VIX Futures: The One Picture to Remember. A rule of thumb is that VIX front month options generally move about half as quickly as the VIX.

If any of these thoughts about VIX options are new to you, then this is not the time to take a flier on VIX options. On the other hand, if you have an understanding on how these products work, it might be a good time to think about the VIX as portfolio insurance.


Alex said...

You could place a bet that the bailout doesn't go through...

Anonymous said...


interesting to see that the VIX,VXO, and VXN close up quite high despite the recovery in the stock market (though declining issues & volume still outnumbered advancing issues & volume.) could it be the 'smart money' is playing this short term rally as a 'dead cat' bounce?


Anonymous said...

I sure hope not Jimmy, because I'm long a whack of VIX 25 Oct puts!

Anonymous said...

When the cat's out of the bag, the chances of a catastrophe are slimmer than usual, not more likely. What we've seen the last 12 months, and will probably continue to see until confidence if resored, is a slow and tortuous bleed down to Dow 7000 or 8000. Much easier money to sell bear call spreads on high IV options whenever the market bounces up.

Anonymous said...

Look beyound the Troubled Asset Relief Plan (TARP). No one has an accounting of the non-performing assets in the financial system. There are best guesses and that is it. The government can build a 850 billion dollar wall, but no one knows for certain, if that will work. I doubt it very much. Why - The hyper inflated real estate craze was global and not just US based.

This Troubled asset releif plan is most definitely troubled. It is insanity. It will be a total failure (long term). I am sure if it passes the market will take off for a while. Lots of volatility on the horizon.

The best way out of this mess is to let the weak institutions fail (as painfull as that may be) and arrest and/or tar and feather Congress and the CIO, BOD and CFO's of these failed companies.

Wait unbtil the FBI is done investigating Fannie and Freddie. There will be massive fraud uncovered.

Anonymous said...

The TED spread flashes trouble. A must read.

1modelcitizen said...

The title of this article is nonsense. SIPC is catastrophe insurance (or so they say). Playing options on the VIX would serve to increase exposure to this market in the case of a catastrophe (like absolute non-liquidity) and is therefore not a form of insurance (although it could serve to hedge).

Earnings Trader said...

I would like to know what price does the VIX futures settle? the spot VIX close price at valuation date, or?


Bill Luby said...

Hi earnings trader,

VIX futures are settled on a special opening quotation of the VIX that is very similar, but not necessarily identical to the cash/spot VIX on the settlement data.

For more information, try: CBOE VIX Futures Settlement Information



John said...

OK, suppose one had a $10MM equity portfolio that had a .8 correlation to the SPX...

How many Vix calls does one need to buy to hedge equivalent to a 90% put on the SPX?

Now with the Vix at ~40, are we really likely to see a 60 or 70 if the SPX falls only another 10% over October? (Not if Vol stays around 40, right?)

In a catastrophe, wait what would that look like from here, as we are already down 20%+ on the SPX... Note to self, just raise cash.and buy some puts, this is too difficult to figure out and probably won't work as well as advertised given all the moving parts of the underlying portfolio (Did I mention the 4% position in JPM?).

Bill, even if you had hedged at the first of the year and seen the increase in the Vix and fall in the S&P YTD, what was the cost of the "insurance" and how well did is pay when we claimed for damages?

Bill Luby said...


You make some excellent points, here and elsewhere.

The VIX can be a good hedge, but there are a number of tricky issues, including:
* correlation -- as you point out, this is generally in the 0.8 range, but it fluctuates
* leverage/multiplier effect -- so the VIX generally moves a little more than 4x the inverse of the SPX, but again, this number is an average and overlooks some significant short-term divergences
* mean reversion and timing -- the VIX (and VIX options/futures) may spike to provide an appropriate level of hedge protection, but these gains can be fleeting when mean reversion kicks in. Sometimes one needs to be a very good trader to capture the value of the hedge before it erodes (and it often erodes faster than the portfolio it is protecting mean reverts)
* floors and ceilings -- two years ago, when the VIX was hovering around 10, you could almost buy an at the money put for free; now that the VIX is 40+ and all but the front month futures are still in the 20s, there is the whole issue of how much bang for the buck you can get from OTM options
* time decay -- since the VIX is such a volatile instrument, IV and time decay are usually very high

This is getting a little lengthy, so perhaps I should elaborate in a future post.

Thanks for kick starting some of the ideas here,


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