Utilizing the VIX as a Hedging Strategy

Utilizing the VIX as a Hedging Strategy

Financial uncertainty, high inflation, considerable equity selling, and recession fears characterize the current financial situation. Since the Covid-19 crisis in 2021, the VIX index, a well-known indication of market volatility, has seen massive jumps while maintaining above-average levels.

Investors are looking for efficient market hedges for obvious reasons, as most portfolios suffer greatly in such conditions. One strategy is to invest in the VIX index, which benefits from its lack of connection with the broader market.

In this article, we will look at the benefits of using the VIX index as a hedge.

The VIX, a Perennial Instrument

The VIX, or CBOE Volatility Index, is a real-time market index that uses options as inputs to track the predicted 30-day volatility of the S&P 500 Index. The VIX is widely seen as a forward-looking indicator of market volatility, often also referred to as the “fear index” or “fear gauge”, since it essentially depicts the expected level of market uncertainty.

When the VIX is low, it implies that the market is calm. In contrast, when the VIX is high, it suggests that the market is fearful and uncertain. The VIX, as shown in this article, is an interesting alternative for insuring against the risk of a stock market drop because it is based on past performance and the fundamental concepts of index volatility.

While the VIX cannot be traded directly, more sophisticated investors wanting volatility exposure can trade the CBOE's futures and options. As we will see in this article, investors can trade some financial instruments (ETNs, for example) that provide direct exposure to the VIX.

Inverse Market Correlation

In general, the VIX and the S&P 500 have an inverse correlation: When the S&P 500 increases, the VIX generally falls, and vice versa.

If the SPX drops, for example, the price of SPX options will often climb as more investors cover their positions and are ready to pay a steeper premium for their options. This is due to the fact that these investors expect the market to be more volatile and are purchasing options to hedge their positions.

Increased market volatility can also enhance the likelihood that option prices will hit their strike price, encouraging option traders to close out their positions and profit. As a result, stock options are likely to be more expensive.

Conversely, when the S&P 500 climbs or remains stable, the VIX tends to fall, as investors do not need to buy portfolio protection as aggressively.

In a nutshell, investors buy the VIX to profit from its value growth characteristics during market downturns, usually in the short term.

2008: Great Recession

Figure 1: Light blue: VIX. Dark blue: S&P 500 (by percent change, between Jan. 2008 and Jul. 2009). Source: CBOE

The market sustained significant losses during the 2008 financial crisis, as evidenced by the S&P 500's 46.13% plunge. Meanwhile, the VIX rose to 80.74 in November 2008, as depicted in this graph, underscoring the market's grim outlook. The SPX and VIX showed a clear negative correlation; Having VIX instruments during this period would have been extremely advantageous.

2020: Covid-19

The same effect was observed recently with the Covid-19 crisis.

Figure 2: Light blue: VIX index. Dark blue: S&P 500 (by percent change, between Feb. 2020 and Feb 2021). Source: CBOE

The VIX reached a high of 531% on March 16, 2020, as a result of the tremendous amount of uncertainty provoked by the pandemic. Despite the market rebounding to 110% of its initial value, the VIX continued to endure periodic spikes in volatility, culminating in a 213% surge on January 29, 2021. Again, holding the VIX throughout this period would have been a wise investment.

Investing in the VIX

As a result of the information presented in this article, it is apparent that trading the VIX can be a valuable hedging technique if carried out correctly, which includes:

  • Analyzing interest rates, inflation, and the current market situation.
  • Checking to determine if the yield curve has inverted.
  • Identifying whether or not the stock market is overvalued.
  • Evaluating the VIX’s value (less/more than 20).

Exposure to the VIX is desirable if the yield curve has been inverted for a long time, if the market looks overvalued, and if inflation is indicating red flags.

Many VIX investing products are available. One of the most popular is the iPath S&P 500 VIX Short-Term Futures ETN (VXX).

Further explanations can be found in the following video:

While these instruments are designed to track the index, their correlation with the VIX is far from perfect; estimates of the correlation have gathered many disparate measurements over time. There is no financial product that can completely replicate the VIX.

To VIX or not to VIX

The VIX should not be considered a long-term investment, but rather an asset that can be employed as part of a short-term hedging strategy. Moreover, investors considering VIX ETFs and ETNs should keep in mind that they are not perfect substitutes for the live VIX's performance. Some may rise or fall in lockstep with the index, but the pace with which they move and the lag time between them can make it difficult, even for seasoned traders, to find efficient entry and exit positions.

Thus, market volatility investing is best suited for investors with a short-time horizon who can closely monitor their positions and react fast if the market swings against them.

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