The S&P 500 is stuck at an all-time high and volatility is at a low level. A feast for every buy-and-hold investor who is delighted with the current rise in prices! However, volatility will not remain low forever. In this blog post, Alexander Eichhorn shows you how buy-and-hold investors can currently hedge the VIX very cheaply.
Current VIX level
The Volatility index VIX is currently trading at a very low level of below 15, which is a bullish sign for the time being. The VIX reached historic highs of over 80 during the financial crisis in 2008/09 and the coronavirus crisis in 2020. These are certainly absolutely exceptional values and I am not saying that the VIX will explode any time soon. However, I think it is currently a good environment to hedge!
If the VIX rises, there is a very high probability that the S&P 500 Index will fall. This will cause share prices to plummet and many short option trades to be stopped out or also cause losses. Therefore, short option holders in particular should also hedge against a rising VIX. However, hedging usually incurs high costs, which is why I will use a spread strategy to keep the costs of the hedges as low as possible.
Hedge with VIX options
Trading volatility is considered the Holy Grail of options trading, and there are many possibilities profitable trades regardless of the market direction! I build my hedges with VIX index options. To do this, we need to look at the VIX term structure curve. This is currently at a very low VIX level (14-15) and the curve is in perfect contango.
Should the markets actually correct, the VIX will generally also rise. At the same time, the VIX futures move in the direction of a backwardation. But beware: a "perfect" backwardation does not necessarily develop. As a rule, however, the front VIX futures in particular rise more sharply than the back ones. In order to take advantage of this effect, it is therefore advisable to create hedges with shorter rather than too long maturities. For this trade example, I therefore take the April options as the middle ground in terms of maturity.
Options on the VIX
- Weekly & Monthly Options,
- Index options (cash settlement)
- VIX options look at the VIX future
- Subscription ratio 1:100
- European options (exercise is only possible at the end of the term)
It is important to understand that the option prices are not calculated on the basis of the VIX index, but on the basis of the respective future expiry.
Let us now take the April future, which has a price of 15.58. This value is determined by the market through supply and demand! The current VIX index stands at 14.70. Now let's look at a 15 put option with an April expiry. Is this option in the money or out of the money? The correct answer: The option is out of the money! This is because the April future (price 15.58) is used to calculate the option price and not the current VIX index value of 14.70! This means that a 15 put option expiring in April has no intrinsic value! This calculation logic is important to understand in order to trade VIX options successfully.
Video tip: VIX workshop: How to trade volatility?
The trade idea
The VIX index is currently at a very low level. It is important to note at this point: The VIX index can remain at a value below 16 for another two years, just because it is low does not mean that the stock market will soon crash and the VIX index has to rise - the VIX does not have to do anything!
Nevertheless, I think it makes sense to hedge against a rising VIX, because if the VIX rises, the stock market will have fallen and many short puts/cash-secured puts will be stopped out or booked and the prices of long-term stocks will fall. At this point I would like to warn you once again: take risk out of your portfolios and trade cash secured puts wisely! Anyone who has not yet experienced a crash cannot imagine how quickly short options can go into negative territory! The best hedge is a well-structured portfolio!
As the VIX index can remain low for a very long time and I don't want to throw too much money at a hedge, we like to choose ratio spreads for the VIX index in particular. More on this in the next section.
Cost-neutral hedging!
I currently like to use so-called ratio spreads, which even make the hedge cost-neutral under certain parameters (but not entirely without risk). A ratio spread consists (here in this example) of a long call in conjunction with two (or more) short calls. Let's take an example (as at 20.02.2024):
- VIX index current level 14.70
- Term April 24 with 56 days RLZ
- Long call at 18 strike $ 120
- 2x short calls at 25 strike $ 60
This results in the following calculation:
Premium issue of the 18 strike of $ 120 + premium income from two short calls at 25 of $ 120 (2x $ 60), so this trade is cost-neutral. Let's get straight to the disadvantage of this trade. It is a hedge, but there is additional risk on the upside of the VIX. Up to a rise of 25, everything is relaxed, because here the long call runs into the money, but the short calls are not yet in the money. From 25, however, two short calls run into the money, but these are no longer offset by a long call option running into the money. Depending on when this happens in the term, it becomes unpleasant from a VIX price of 25-30.
Options traders should therefore intervene as soon as the long call option goes into the money. The worst-case scenario would be a VIX rise overnight from 12 to 50, for example, as it would no longer be possible to intervene. I would buy back the short options at around 80 % loss in value, then a pure long call remains in the portfolio as a hedge.
This ratio spread is cost-neutral; as soon as the VIX rises, this spread is in profit. However, this trade is not suitable as a black swan hedge, as the profit potential here is also capped at 25 or can even go into negative territory. I like to use these ratio spreads, so I have a hedge for small to medium VIX increases in my portfolio.
It is also advisable to place several ratio spreads with different strikes and maturities in the portfolio. If nothing happens in the VIX for a while, the short options can be closed in profit and pure long calls remain in the portfolio!
Conclusion
The VIX is currently very low, but this alone is not a sign of a crash. Volatility can remain low for a very long time, which is why hedges should be treated with caution. Investors need to find the balance between building up hedges and not spending too much on them. That's why I use ratio spreads to benefit from both.
