Hedging My Equities With VIX

Prieur du Plessis Postcards from Cape Town April 23, 2010

Fri 23 Apr 2010

Posted by Prieur du Plessis under Investment, Stocks [3] Comments

I have often in the past referred to the CBOE Volatility (VIX) Index, also known as Wall Street's "fear index". This is a measure of the implied volatility of S&P 500 index options "“ a high value corresponds to a more volatile market and therefore more costly options.

The VIX Index is an excellent contrary indicator, moving in the opposite direction to stocks, and worth keeping an eye on. The Index peaked at 80.9 in November 2008 and has since declined to a low of 15.6 beginning March before edging up a bit to 16.4. To add some longer-term perspective, the relatively calm four-year period prior to the start of the credit crisis was characterized by a range between 10 and 20.

The graph below shows the neat historical inverse relationship between the S&P 500 Index (black line) and the VIX (red).

Source: StockCharts.com

I am of the opinion that the nascent cyclical bull market is looking tired, on top of the fact that stocks over over-loved, overbought and overvalued. But let's also get a second opinion on the matter and who better than from David Fuller (Fullermoney) from across the pond. He said: "Over the last fortnight I have repeatedly mentioned that the excellent stock market rally over the previous nine to ten weeks was becoming increasingly overextended relative to the mean for numerous trends. Last Friday and also this Monday, we saw a number of downward dynamics for many important stock market indices, such as the Dow Jones Industrial Index, the Shanghai Composite Index, the Switzerland SMI Index and the Australia AS&P ASX200 Index. Where they occurred, they interrupted short-term upward trends, indicating that a reaction and consolidation had commenced. I have also mentioned that this could turn into a mean reversion correction for some stock markets.

"I do not think we are witnessing the onset of new or renewed bear markets. However, there have been some blows to investor confidence recently "“ mainly deteriorating sovereign debt problems, China’s monetary tightening to check property speculation, and the SEC’s case against Goldman Sachs. These events have checked upward momentum for most stock markets at a time when they were technically overstretched in the short term. Lastly, debt concerns prevented southern European stock markets from participating in the February to mid-April uptrend extension rallies seen elsewhere and laggards such as Greece, Portugal and Spain are trading below their moving averages."

Back to the VIX: One way of hedging an equity portfolio is to bet on increased volatility that is bound to happen with any stock market correction. One can do this by buying either the iPath S&P 500 VIX Short-term Futures ETN (VXX) or iPath S&P 500 VIX Mid-Term Futures ETN (VXZ). VXX invests in VIX futures contracts ending within the next two months, whereas VXZ is made up of VIX futures contracts running for four to seven months. A word of warning, though: these products generally represent an excellent way of hedging against stock market declines, but may not always fully track the VIX as a result of investing in futures that are also affected by other risk factors.

The graph below shows the VIX Index (red line) together with both VXX (green) and VXZ (blue).

Source: StockCharts.com

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More on this topic (What's this?) Investor Sentiment Volatility (Disciplined Approach to Investing, 4/22/10) Long Volatility Intuitions Are Not Your Friend (Condor Options, 3/30/10) How to Profit From Volatility Through One Simple Investment (Investment U, 1/19/10) Read more on Historical Volatility, Volatility Index (VIX) at Wikinvest

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Email Digg Del.icio.us Technorati Stumble Reddit Facebook « Marc Faber "“ governments will “bankrupt us” | 3 Responses to “ I have just hedged my equities by going long volatility ” Comments: Kevin McGivern says: April 23rd, 2010 at 3:41 pm

Why not simply sell? Or sell index futures? Has to be much simpler and with a more manageable basis, so what am I missing?

Rgds

Prieur du Plessis says: April 23rd, 2010 at 6:33 pm

@Kevin: I won’t be surprised if volatility bet outperforms a vanilla S&P 500 short once a correction gets going.

Kevin McGivern says: April 23rd, 2010 at 8:06 pm

I’m not sure I’d be surprised either but why would that be my expectation? Or what degree of confidence should I have about that?

I guess I’m just struggling to understand what you know about the basis risk here.

Thanks for your attention.

Best regards

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Why not simply sell? Or sell index futures? Has to be much simpler and with a more manageable basis, so what am I missing?

Rgds

@Kevin: I won’t be surprised if volatility bet outperforms a vanilla S&P 500 short once a correction gets going.

I’m not sure I’d be surprised either but why would that be my expectation? Or what degree of confidence should I have about that?

I guess I’m just struggling to understand what you know about the basis risk here.

Thanks for your attention.

Best regards

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Calendar April 2010 M T W T F S S « Mar 1234 567891011 12131415161718 19202122232425 2627282930 Recent Posts I have just hedged my equities by going long volatility Marc Faber "“ governments will “bankrupt us” Prieur's readings (April 23, 2010) Unveiling the new $100 Benjamin IMF: No China asset bubble, healthy growth to continue Recent Comments Kevin McGivern on I have just hedged my equities by going long volatilityPrieur du Plessis on I have just hedged my equities by going long volatilityflyboy on Debt "“ the Achilles heel of the US economyKevin McGivern on I have just hedged my equities by going long volatilitybob on Gold, oil and Apple, according to the charts Archives April 2010 March 2010 February 2010 January 2010 December 2009 November 2009 October 2009 September 2009 August 2009 July 2009 June 2009 May 2009 April 2009 March 2009 February 2009 January 2009 December 2008 November 2008 October 2008 September 2008 August 2008 July 2008 June 2008 May 2008 April 2008 March 2008 February 2008 January 2008 December 2007 November 2007 October 2007 September 2007 August 2007 July 2007 June 2007 May 2007 March 2007 Blogroll Active Trading ETF’s Alfidi Capital Barry Ritholtz’s The Big Picture BBC News BCA Research BlogNetNews Bloomberg.com Brett Steenbarger’s TraderFeed Calculated Risk Chart of the Day CNN Money CNN.com Coins Daily Reckoning Forum David Fuller DealBreaker Dismal Scientist Doug Casey EconomPic Data Emerging Index ETF trends ETFs – Wall Street Sector Selector Financial Armageddon Financial Web Forbes Fortune Free credit score FT Alphaville Global property database Global Property Guide GoldSeek Green Stocks Greenlight Advisor Howard Lindzon Investment Advice itrade4real.com Jeremy Grantham’s GMO Jim Sinclair’s MineSet John Bougearel’s Trading Tips John Hussman John Mauldin King World News Kitco MarketBeat MarketWatch Michael Nystrom’s Bull (Not Bull) Minyanville Naked Capitalism News N Economics Nouriel Roubini Online Stock Brokers Option Writer Payday loans PIMCO Plexus Asset Management QFINANCE Random Roger’s Big Picture Real Clear Markets Richard Russell’s Dow Theory Letters Richard Wilson’s Hedge Fund Blog Robin Hood Trader RunToGold SafeHaven Scott’s Investments Seeking Alpha Self Investors SmartMoney.com Stock Trading Stock Trading Ideas Stock Trading System – Fusion IQ Stock Trading to Go StockCharts.com Stocks Info StockWeb Telegraph The Economist The Financial Times The Kirk Report The Market Oracle The Motley Fool The New York Times The Wall Street Journal Online The Washington Post The Washington Times TheStreet.com Times Online Top Foreign Stocks Trading Software Wall St Cheat Sheet WallStraits WallStreetBear WallStreetWindow Stock Trading Wallstrip.Com Wang’s Happy Trading WordPress.com World Gold Council Yahoo Finance Follow These Too Amazon.com Widgets Recent Readers Powered by BlogCatalog

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Hedging My Equities With VIX

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