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Hedging Equity Risk with VIX Futures

One of the most difficult aspects in long-term investing is to keep your long investments on even though you feel like there just *has* to be an equity correction coming soon.  Your traditional options are simple: 1) hold on/pray or 2) sell everything and hope for a correction that comes with a sign of when to get back in.  Those two methodologies leave a lot to be desired.  The second level of sophistication involves: 1) shorting equity futures against your long stock positions, 2) selling call options on the stocks you own (covered calls), or 3) buying put options on the individual stocks or the index overall.  These are better ways to take some chips off the table, but they still leave a bit to be desired.

The advent of VIX futures has given investors another tool to consider when looking to protect equity portfolios.  For those who are regular readers, you might know that I believe volatility will be a recurring theme as we sift through macroeconomic problems, debt, and unemployment.  Volatility usually means there will be sharp pullbacks and further rallies.  The markets could trend upward over time with strong corrections, they could be choppy and range-bound or they could be vehemently negative.  I do not know which will occur, but I am more willing to bet on 20% realized volatility than I am willing to bet on sub 10% volatility (which is where the 30 day realized volatility currently resides).

The realized volatility has had some upward spikes, but it is now sitting at levels not seen since 2007

With that as the backdrop, it is interesting to research what type of trades make sense in this environment.  In another piece, I suggested a Long Gamma, Short Vega position which many might feel is a bit too complicated.  Today, I want to start looking at a rather new strategy which makes a lot of sense for long-term equity investors.  If you are long stocks then you will lose money when equity markets decline (obviously).  When equity markets decline, implied volatility on options increases as more investors buy put options.   Therefore, as a long equity investor, you can often benefit by having a long position in volatility to hedge against downside tail events in the equity markets.  The problem is that many long volatility positions are very expensive to hold over time.

The VIX Index is a good proxy for the 30-day implied volatility of S&P 500 options. VIX futures trade the forward expectations for the VIX Index.   By trading VIX futures you are making a bet as to what the 30-day implied volatility will be at some point in the future.  What is important about VIX futures is the forward curve:

The VIX futures curve exhibits contango under low volatility markets

What this forward curve tells you is that if you buy a VIX futures contract you will lose money by holding it just because the contract decays in value (rolls down the curve).  This effect is most destructive when holding a futures contract with a nearer maturity.  In this case, if you look at holding the Sep 2010 VIX future it loses 2.17% over two months while the Jun 2010 loses 15.97% over two months.  This will obviously change as the shape of the curve changes, but if you pay attention to the forward curve you can make strategic second-order decisions that will make your VIX trading much more profitable.  I will discuss how to utilize this information with the Barclays exchange traded notes VXX and VXZ next time.

Posted in Derivatives, Markets, Trading Ideas.

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