Hedging VIX Volatility an Advanced Strategy

Option traders scramble for insurance as the VIX jumps

   

With the continued turmoil in Egypt the market has seen a nice up tick in implied volatility (IV). As I have been telling my options trading students, just because IV is up, it does not mean it is a good sale. That said, I think there are plenty of trading opportunities out there. With IV and skew way up relative to where we have been other traders may decide they want to sell iron condors. Looking at those traders, there is some validity to that argument.

There is a risk associated with these trades, as it’s the process of going from low to high that will blow you up. It is important to insure a trade unless one is selling extremely high implied volatility. With all that is going on in the world a 20 CBOE Volatility Index (VIX) doesn’t seem astronomically high. However, it is the highest IV we have seen in several months. The skew is, in relative terms, super steep as well. This is a great thing and a bad thing for most traders.

MarkS1 Hedging VIX Volatility an Advanced Strategy

Implied Volatility and SPX Index

It is great because we finally have something that we can sell premium on. An April Iron Condor has more juice in it and is wider than it normally would be here. It is a problem because insurance can be a problem when volatilities are high. So how should one hedge their short premium positions?

The first option is to use standard put insurance, as this was extremely cheap about two weeks ago. When I was writing about skew, the VIX was sitting at around 16 – 17, and we had an at-the-money (ATM) IV of around 14%. I believe the skew bottomed out at about 132% of ATM IV. That gave the downside put an IV of about 19.5% … a very low number. Today, that skew is trading at over 150% of ATM IV, and IV is about 2 points higher at close to 16%. That puts our downside put at more like 24%, an increase of 4.5% (this was even a bigger increase on Friday). That is more than double the IV increase we see in the ATM’s. If one had used puts two weeks ago, they would be in lovely shape, the question is now what? What if ATM IV goes from 16 to 19?

If we increase the ATM IV to 19%, the put will make money but the skew could flatten back down to a normal range … closer to 135%. That would mean our downside put has an IV of about 25.65, an increase in IV of less than 2 points, or about 55% of our increase in ATM IV. While it is hedging us some, it is not doing an effective job given the cost. This is the danger of insuring a steep skew.

Our second option is to use VIX calls, and sometimes these calls can be a terrible trade, most commonly when they are in deep contango, a situation where the futures are more expensive than the cash. The wider this contango, the less correlated the futures seem to be with the cash market, and thus SPX implied volatility. However, when we get a spike like we just had, something special can happen.

A trader may be able to hedge the vega risk of a portfolio with some success using Feb or March futures or call options. With Feb IV somewhat high, March seems to make the most sense despite its volatility being elevated and the slight contango. I think an increase in IV will not only cause the March VIX future to rally, but we will see IV in VIX calls increase. This could allow VIX calls to capture up to 70% of an increase in ATM IV.

Mikes2 Hedging VIX Volatility an Advanced Strategy

VIX Implied Volatility

If the VIX calls can capture 70% of the increase in volatility versus 55% in the SPX, does this mean that we want to use VIX calls? Not necessarily, because the delta and time decay functions matter in SPX. We can pick up more value in the option if the market falls along with the increase in IV. This is a second factor. There are times where this can outweigh any kind of skew problems. However, often over the period of a week it does not, especially if the market swings back. Using VIX calls or VIX futures is not easy to understand, heck downside puts can be a quandary sometimes. It is important to sit down and look at the best hedge, and that will lead you to the Promised Land known as ‘returns.’

Follow Mark Sebastian on Twitter @optionpit.


Article printed from InvestorPlace Media, http://investorplace.com/2011/02/hedging-vix-volatility-cboe-volatility-index/.

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