Is there more interest in hedging and protecting portfolios in 2018? The May 31st Striking Price column in Barron’s noted --

“Investors Return to Hedging in Volatile Times.  Traders leery of sharp declines after a wild few months in the U.S. equity markets could spring for stock hedges through options.  …  This year, trade tensions and other geopolitical problems appear more likely to sway stocks, in sharp contrast to the placid markets of 2017.  … “

Investors have asked me if long call options on the Cboe Volatility Index® (VIX®) may be used to help dampen the left-tail risk in equity portfolios. Many long VIX call options positions have the potential for an increase in value when stock prices take a big fall.  For investors who are trying to gain a better understanding of how long VIX call options might have impacted portfolios during past market cycles, (including past bull and bear markets) two resources that can be helpful include –

  1. The Cboe VIX Tail Hedge IndexSM (VXTHSM), a benchmark index with hypothetical performance since March 2006; and
  2. UMass paper on “VIX Futures and Options-A Case Study of Portfolio Diversification During the 2008 Financial Crisis" (full version)" and 2-page summary.

CBOE VIX TAIL HEDGE I (VXTH) Index

The VXTH Index tracks the performance of a hypothetical portfolio that – (1) Buys and holds the performance of the S&P 500® Index (the total return index, with dividends reinvested), and (2) Buys one-month 30-delta VIX call options. The weight of the VIX calls in the portfolio varies at each roll. If the one-month forward value of the VIX Index at the time of the monthly roll -- (1) is below 15% or above 50%, the portfolio weight of VIX calls is 0%; (2) is between 15% and 30%, the portfolio weight of VIX calls is 1%; and (3) is between 30% and 50%, the portfolio weight of VIX calls is 0.5%. For more information and the roll schedule, please visit www.cboe.com/VXTH

 

LESS VOLATILITY FOR VXTH INDEX THAT BUYS VIX CALL OPTIONS

Over the 10-year period ending May 31, the VXTH Index had a lower annualized standard deviation than key stock indexes and a key commodity index (see chart below).  


V-01-01-VXTH standard deviations bar chart

 

LESS SEVERE DRAWDOWN FOR VXTH INDEX THAT BUYS VIX CALL OPTIONS

Since April 2006 the worst peak-to-trough drawdown for the VXTH Index was down 37.4%; this drawdown was less severe than the drawdowns for key stock and commodity indexes (see chart below). The value of long VIX call options positions has the potential to rise in the event of big stock market declines.


V-01-02-VXTH Drawdowns bar chart

VXTH HAD HIGHER RETURNS THAN CERTAIN KEY INDEXES

As shown in the next chart, since March 2006 the VXTH Index had higher returns than the MSCI EAFE, S&P GSCI, and 30-year Treasury Bond Indexes. However, in light of the recent 9-year bull market for stocks, the returns for the S&P 500 Index were higher than those of the VXTH Index. The table below shows that in 2008 the S&P 500 Index fell 37%, the S&P GSCI Index dropped 46.5%, and the VXTH Index fell 19.3% (the VIX calls bought by the VXTH Index were able to cushion the fall that year).  

V1-01-03-VXTH line chart

 

UMASS STUDY - OTM VIX CALLS ADDED VALUE IN LATE 2008

Figure 5 of the 2-page summary of the UMass paper on “VIX Futures and Options - A Case Study of Portfolio Diversification During the 2008 Financial Crisis" presents the performance of three hypothetical portfolios from March 2006 through Dec. 2008. The portfolios had allocations to “E/B/A” (Equities, Bonds and Alternatives) and to long VIX calls that were 25% OTM (out-of-the-money). 


V-01-04-UMass OTM VIX call line chart

According to Figure 5 above, during the period from March 2006 through December 2008 –

  • Up 14.01% (black line above) - the portfolio with a 3% allocation to 25% OTM long VIX calls generally trailed the other two portfolios from March 2006 through mid-2008, as there are costs to buy the VIX call options. However, the allocation to VIX calls helped the entire portfolio sharply rise in the fall of 2008, and by the end of 2008 the portfolio was up 14.01%.
  • Up 2.71% (red line above) - the portfolio with a 1% allocation to 25% OTM long VIX calls generally trailed the E/B/A portfolio from March 2006 through mid-2008, but by the end of 2008 aggregate returns for the portfolio with a 1% allocation to 25% OTM long VIX calls were more than 17 percentage points higher than the E/B/A portfolio.
  • Down 14.82% (blue line above) The E/B/A portfolio (with no allocation to VIX call options) generally outperformed the other portfolios through mid-2008 but dropped in the fall of 2008.

 

CONCLUSION

If you are concerned that trade tensions and other geopolitical challenges could have a negative impact on future stock market performance, you may want to explore the possible use of long VIX call options and the VXTH Index.

 

Past Performance is not indicative of future results. Options involve risk and are not suitable for all investors.  Prior to buying or selling an option, a person must receive a copy of “Characteristics and Risks of Standardized Options.”  Copies are available from your broker or from The Options Clearing Corporation at One Wacker Drive, Suite 500, Chicago, IL 60606 or at www.theocc.com. Futures trading is not suitable for all investors, and involves the risk of loss.  The risk of loss in futures can be substantial.  You should, therefore, carefully consider whether such trading is suitable for you in light of your circumstances and financial resources.  For additional information regarding futures trading risks, see the Risk Disclosure Statement set forth in CFTC Regulation §1.55(b). The views expressed herein are those of the author and do not necessarily reflect the views of Cboe Global Markets, Inc. or any of its affiliates.