Risk Management with VIX Options and Futures: Capital Protection Through Portfolio Diversification and Hedging

This article was prepared in connection with the launch of Mini Cboe Volatility Index (Mini VIXTM) futures on Cboe Futures Exchange, LLC (CFE). Before you trade Mini VIX futures, it's important to understand the following:
  • Mini VIX futures are complicated financial products that are suitable only for sophisticated market participants.
  • Mini VIX futures involve the risk of loss, which can be substantial and can exceed the amount of money deposited for the futures position.
  • Market participants should put at risk only funds that they can afford to lose without affecting their lifestyles.
  • Before transacting in Mini VIX futures, market participants should fully inform themselves about the characteristics and risks of Mini VIX futures, including in particular those described below. Mini VIX futures market participants also should make sure they understand the product specifications and the methodologies for calculating the underlying VIX® Index and the settlement values for Mini VIX futures.

The foremost concern for most investors tends to be capital protection, even when the additional objective of income generation is present.

The VIX suite of products uniquely affords market participants the opportunity to potentially insulate their capital from the risks associated with large, unexpected market moves. Because VIX futures and options often demonstrate performance that is inversely correlated with the U.S. stock market, this feature may offer a diversification element when added to an investor's portfolio.


 

Research studies suggest that relatively small allocations to VIX futures or options-based strategies may mute the impact of sharp S&P 500 Index declines. Most recently, Prof. Edward Szado released a study examining the performance of strategies that buy VIX futures or VIX call options as well as alternative strategies, including long S&P 500 Index protective put strategies, as part of a protective portfolio allocation.


Practitioner's Guide to Volatility Products

VIX futures and options enable market participants to gain exposure to expected market volatility that has been isolated, which is independent of overall market direction. Most passive market participants are "long only" and tend to benefit from markets that move higher over time. Those positions are implicitly "short volatility." As such, VIX futures and/or options may be used to hedge portfolios against volatility shocks when used passively or, when used strategically, may be used to potentially reduce overall portfolio risk.

Recall the negative correlation relationship between the S&P 500 Index and VIX futures. With the understanding that a hedge is something that has a value because it moves in the opposite direction of the asset you're looking to protect, one can see why the VIX product complex is potentially a compelling addition to a diversified portfolio.



 

Cboe Benchmark Indices

The Cboe Benchmark Indices measure the performance of hypothetical strategies using index options, VIX options or VIX futures.


Cboe VIX Tail Hedge Index (VXTH)

Strategy: VIX call option buying

VXTH illustrates the effect of incorporating a VIX call option buying strategy in a portfolio that is long the U.S. Equity market.



VXTH was higher by roughly 92% in late July, which compares to an S&P 500 Index that measured unchanged on the year.

  • Buys one-month 30-delta VIX call options.
  • New VIX call options are purchased monthly, a procedure known as the "roll."
  • The weight of the VIX call options in the portfolio varies at each roll and depends on the forward value of VIX Index, an indicator for the perceived probability of a "swan event."

For more information, cboe.com/VXTH


Additional Information before you trade Mini VIX futures:

  • Underlying Index: Mini VIX futures are based on the VIX Index, which is a financial benchmark designed to be a market estimate of expected volatility of the S&P 500®. The VIX Index is calculated by using the midpoint of quotes of certain S&P 500 Index options. (More information on how the VIX Index is calculated is available here and here.)
  • Not Buy and Hold Investment: Mini VIX futures are not suitable to buy and hold because:
    • On their settlement date, Mini VIX futures convert into a right to receive or an obligation to pay cash.
    • The VIX Index generally tends to revert to or near its long-term average, rather than increase or decrease over the long term.
  • Volatility: The VIX Index is subject to greater percentage swings in a short period of time than is typical for stocks or stock indices, including the S&P 500 Index.
  • Expected Relationships: Expected relationships with other financial indicators or products may not hold. In particular:
    • Although the VIX Index tends to be negatively correlated with the S&P 500 Index-such that one tends to move upward when the other moves downward and vice versa-that relationship is not always maintained.
    • The prices for the nearest expiration of Mini VIX futures tend to move in relationship with movements in the VIX Index. However, this relationship may be undercut, depending on, for example, the amount of time to expiration for the Mini VIX futures contract and on supply and demand in the market for those futures.
    • Mini VIX futures contracts trade separately from regular-sized VIX futures, so the prices and quotations for Mini VIX futures and regular-sized VIX futures may differ because of, for example, possible differences in the liquidity of those markets.

This article also addresses Cboe Volatility Index (VIX®) options offered for trading on Cboe Exchange, Inc. (Cboe Options) and regular-sized VIX futures offered for trading on CFE. In addition to the above, it's important to understand the following before you trade VIX options and VIX futures:

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 125 S. Franklin Street, Suite 1200, Chicago, IL 60606 or at www.theocc.com. Futures trading is not suitable for all investors and involves the risk of loss. That risk of loss can be substantial and can exceed the amount of money deposited for a futures position. You should, therefore, carefully consider whether futures trading is suitable for you in light of your circumstances and financial resources. You should put at risk only funds that you can afford to lose without affecting your lifestyle. For additional information regarding futures trading risks, see the Risk Disclosure Statement set forth in Appendix A to CFTC Regulation 1.55(c) and the Risk Disclosure Statement for Security Futures Contracts.

The information in this document is provided solely for general education and information purposes. No statement within this document should be construed as a recommendation to buy or sell a security or futures contract or to provide investment advice. The Cboe VIX Tail Hedge IndexTM (the "Index") is designed to represent proposed hypothetical strategies. Like many passive benchmarks, the Index does not take into account significant factors such as transaction costs and taxes. Investors attempting to replicate the Index should discuss with their advisors possible timing and liquidity issues. Investors should consult their tax advisor as to how taxes affect the outcome of contemplated options transactions. Past performance does not guarantee future results. It is not possible to invest directly in an index. Your use of, and access to, this paper is subject to the Terms and Conditions for Use of Cboe Websites located at http://www.cboe.com/common/termsconditions.aspx.

Cboe®, Cboe Global Markets®, CFE®, Cboe Volatility Index®, and VIX® are registered trademarks and Cboe Futures ExchangeTM, Mini VIXTM and VXTHTM are service marks of Cboe Exchange, Inc. or its affiliates. Standard & Poor's®, S&P®, S&P 500®, and SPX® are registered trademarks of Standard & Poor's Financial Services, LLC, and have been licensed for use by Cboe Exchange, Inc. All other trademarks and service marks are the property of their respective owners. © 2020 Cboe Exchange, Inc. Any products that have an S&P Index or indices as their underlying interest are not sponsored, endorsed, sold or promoted by S&P OPCO LLC ("Standard & Poor's"). All Rights Reserved.