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Hedging With the VIX?

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It stands to reason that if volatility increases when markets go down, then being long volatility would help offset some of that market loss. But is that actually the case?

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As a long-term investor, these wild swings in the market don't take quite the toll on me that they take on traders that are trying to predict these swings. I am invested for the long haul – so intraday movements don't concern me that much.

However, wild price swings fuel the fear and paranoia in the market and, as a result, generally feed the bear market more than they feed a bull market. Bear markets do concern me. As a long-term investor, I am more often long the market than short the market.

These wild swings are called market volatility. Every market decline greater than 10% in the last 20 years has been characterized by higher market volatility.

Volatility can be measured. And since it can be measured, Wall Street has built investment mechanisms that are indexed to it. The most popular investment vehicle is the CBOE Volatility Index (^VIX). You can purchase or sell calls and puts on this index for many strike prices from one month to six months from today.

So, if volatility tends to feed and/or be a characteristic of a bear market, can we use that knowledge to build a hedge for our portfolio? It stands to reason that if volatility increases when markets go down, then being long volatility would help offset some of that market loss.

The VIX is a very liquid, high-volume options market on volatility so we can test this hypothesis. At my firm, we decided to run some back-tests and see if investing in volatility would have acted as a successful hedge against the market declines since 2008.

For the long-term investor, looking backward, the results were mixed at best. And looking forward, it looks like the long-term investor should avoid using the VIX as a hedge.

Our back tests definitely showed very good results for using the VIX as a hedge in late 2008 and early 2009.
In fact, if you had set aside 7% of your portfolio in 2008 for routine purchases of at-the-money calls in the VIX, your market-indexed portfolio would have only declined by about 10% versus the wider market decline that year of greater than 35%. If you set aside 10% of your portfolio for these calls instead, you actually would not have lost money at all in 2008. Quite a feat really.

If you kept the routine purchase of at-the-money calls in the VIX going in to early 2009, you would have had a very large profit on the January VIX calls. On the 7% program, you would have been close to break-even. On the 10% program, your overall market-indexed portfolio would have made a profit. And if you regularly re-invested your profits from the VIX in to broad market index, you would have held 40% more shares at the end of 2009 than you started with in 2008. Imagine all of those extra shares poised for the rebound that followed the market collapse of late 2008 /early 2009.

The success of the VIX calls ahead of the market collapse of late '08/early '09 should not surprise the reader. The market could not have forecasted such a dramatic drop in market prices. As a result, the price of the at-the-money VIX calls were quite a bargain, in retrospect. The collapse in market prices was historic in size and velocity – on par with the collapse of 1929, really.

Many of the VIX calls were bought at strikes around $20 or $30 and the VIX eventually traded in the $50s, $60s, and $70s. So, if you were in a regular VIX call purchase strategy going in to that collapse, you made out quite well. But what has happened since then?
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No positions in stocks mentioned.
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