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For Traders Only: How to Hedge With Volatility


Using the volatility index to create a short term hedge.

On January 26, a friend asked me if there was a way to hedge using volatility as a means to counterbalance his bullish portfolio. Like most traders, he felt that the S&P 500 was nearing a resistance level and wanted profits if there was a pullback. We all know what happened on Friday the 28th; the markets had a sell-off post the news out of Egypt to the tune of nearly 2%. Smart guy… and I'm sure I'll hear about it for months about how he played the 75-point drop in the Nasdaq like Charlie Daniels plays the fiddle (thanks for that one Geico).

Volatility is typically represented by the VIX, which is the volatility of the S&P 500, notoriously referred to as the fear factor of the market. The two have an inverse relationship; however it's not linear. Consequently, one can expect the VIX that has a beta of -4.4 to rise when the market drops or has wild daily swings.

Unfortunately, not all investors have ways to trade the VIX. There are alternatives in the form of exchange-traded notes, or ETNs, like iPath S&P 500 VIX Short-Term Futures ETN (VXX) and iPath Long Enhanced S&P 500 VIX (VZZ) that trade like an ETF and are designed to reflect the short or mid-term performance of the VIX.

See What Is the VXX? for more

Realize that these are derivatives based on derivatives based on derivatives, and all iteration has its own nuances to consider. Like Michael Keaton's character Doug Kinney #3 said in Multiplicity: "You know how when you make a copy of a copy, it's not as sharp as…well…the original." Each time you take a derivative, the replication isn't as sharp as its predecessor. Here's an example of what I mean from the S&P 500 to a hedge with options using the VXX:

500 stocks create the SPX (S&P 500 index) (first derivative)
2. Options trade based on the SPX (second derivative)
3. The VIX futures track the implied volatility of those SPX options (third derivative)
4. The VXX is an ETN that trades based on the VIX futures (fourth derivative)
5. Options are now traded on the VXX that can be used to create a hedge (fifth derivative)

The Hedge Position

Let's get back to the trade. One technique to consider when volatility is on the rise is a near-the-money bull call spread on the VIX. Here's an example:

  • Buy Mar '11 VIX 16 Call

  • Sell Mar '11 VIX 17 Call

  • Net Debit of about $0.65

    • VIX closes above $17 at Feb expiration, yields the max gain of $0.35

    • VIX closes below $16 at Feb expiration, yields the max loss of $0.65

    • VIX at $16.65 is breakeven

One should note, this is a short-term position and is more of a trader's hedge than an investor's. I say that because the VIX can move pretty quickly in a single day and if this position is to be employed, it should be by someone that stays connected on a regular frequency.

Why Choose the Bull Call Spread

I like near-the-money debit call spread because the market actually doesn't have to move very far in my projected direction for it to pay off. Technically, with the VIX at 16.69, this is already above its breakeven point of 16.65, and any spike in volatility will push the VIX over 17, yielding the max gain of 53% (.35/.65).

If our belief is a decline in the SPX, ergo an increase in the VIX, it means we want a bullish position in VIX. There are many different ways to do that, here are three to consider:

1. Buy the VXX ETN outright
2. Buy calls on the VXX or VIX
3. Bull Call Spread on the VXX or VIX

I've already said I like third the best and I'll explain a little more by showing the downside of the other two.

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No positions in stocks mentioned.
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