fbpx More On: Protecting A Stock Portfolio With $VIX Options (15:07) | Option Strategist

More On: Protecting A Stock Portfolio With $VIX Options (15:07)

By Lawrence G. McMillan

This article was originally published in The Option Strategist Newsletter Volume 15, No. 7 on April 14, 2006. 

Areader question regarding last issue’s feature article indicates that some expansion on the topic might be useful.

Q: In TOS1506, you discussed the use of VIX calls as a hedge for a stock portfolio. However, I can’t see how the example you used of hedging a $1M stock portfolio by purchasing enough calls to be long $100,000 (10%) VIX constitutes an adequate hedge.

If a 10% market correction occurs, the $1M portfolio would have an unrealized loss of $100,000. If VIX rises 15 points (the top of the expected increase in VIX with a 10% correction) and VIX is at 26.5, each call with a 17.5 strike would be worth $900. On a hedge of 57 calls, the value of the hedge is 57 x $900 = $51,300. Subtracting the initial investment of $13,400 (per the example in the TOS article), the gain is only $39,900 – just less than 4% of the stock portfolio’s initial value.

Please explain why this is a valid hedge. Could it be that a hedge as such is incomplete? Am I missing something? – T.N.

A: The use of a 10% VIX hedge comes from the Merrill Lynch study cited in the article, done in 2003. The study concluded 10% was an appropriate hedge – and it is, if you're using $VIX itself.

In this example, however, the $VIX calls are out of the money, so the stock owner is assuming some risk to begin with. $VIX was assumed to be 11.58, so the use of the 17.5 strike means that the hedge doesn’t take effect until $VIX has already risen substantially. It's similar to buying puts for protection, but using a strike that's well out of the money.

On the other hand, if you had bought at-the-money $VIX calls, say the 12.50 strike, then the hedge would take effect almost immediately, although it would cost more. Let’s look at an example, using the 12.5 strike calls:
Example: $VIX = 11.58 Feb (‘07) 12.5 call= 4.00

As before, to determine the number of calls that one must buy, it is first necessary to determine how much of your portfolio to hedge. In this case, we are hedging 10%, or $100,000 of the $1 million stock portfolio.

Then divide that amount by the value of the $VIX striking price, in dollars. # of calls to buy = $100,000/1250 = 80

Since each call costs $400, the total cost of this hedge is $32,000. But if $VIX jumps to 26.5 during a 10% market correction – as suggested in the above question – then these calls would be worth $1,400 each. That’s a profit of $1,000 on each call, or a total hedge profit of $80,000 – 8% of the portfolio.

If $VIX rose just a bit farther – to 29 – each $VIX call would be worth $1,650, and you’d cover the entire loss of your stocks. So it is up to the hedger to decide if he wants to spend the extra money up front ($32K vs. $13.4K) in return for better protection if the market corrects.

 

This article was originally published in The Option Strategist Newsletter Volume 15, No. 7 on April 14, 2006.  

The Option Strategist Newsletter $29 trial

Share this

Option Strategist
Blog Search

Recent Blog Posts

Trading or investing whether on margin or otherwise carries a high level of risk, and may not be suitable for all persons. Leverage can work against you as well as for you. Before deciding to trade or invest you should carefully consider your investment objectives, level of experience, and ability to tolerate risk. The possibility exists that you could sustain a loss of some or all of your initial investment or even more than your initial investment and therefore you should not invest money that you cannot afford to lose. You should be aware of all the risks associated with trading and investing, and seek advice from an independent financial advisor if you have any doubts. Past performance is not necessarily indicative of future results.
Visit the Disclosure & Policies page for full website disclosures.

-->