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1. SECTION V
Volatility Analysis

2. CHAPTER 22
Hedging with VIX
Derivatives

3. Introduction
▪ VIX derivatives comes into play due to the inverse
relationship between market implied volatility and the
direction of stocks.
▪ Volatility-related trading vehicles continue to be
introduced, the two most commonly used hedging
vehicles are VIX index options and futures.
▪ The main focus of this chapter is how VIX index
options and futures are used to hedge equity
portfolios.
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4. Hedging with VIX Options
▪ Contracts that have a strike very close to the underlying security price
are referred to as being at the money.
▪ Higher open interest around the at the money contracts is typical of
most option series, whether index, equity, or exchange-traded fund.
▪ At the money option contracts are usually the most actively traded
along with having the highest open interest.
4 Dec VIX Index Call Option Open Interest, Late November 2010

5. Hedging with VIX Options
▪ The reason behind high open interest for VIX index option contracts that
are 10 to 20 points out of the money emanates from how investors
have started to use VIX options for hedging.
▪ Many institutions will buy out of the money VIX calls as a version of
disaster insurance on the overall equity market. The expectation is that
the VIX index and futures contracts will rally in a magnitude that is in
excess of the movement to the downside that would occur in the S&P
500 index.
5 S&P 500 Index and VIX Performance from Aug to Nov08
In times of market turbulence, the
VIX index often rallies in a
magnitude that is many times that
of the drop of the S&P 500 index.

6. Hedging with VIX Options
▪ A couple of unique difficulties arise regarding using out of the money
VIX call options to hedge an equity portfolio. What strike to choose
would be an initial consideration with how many to purchase being a
secondary concern.
▪ When traders or portfolio managers are concerned about potential
portfolio losses, but not willing to pay the option premium for
protection, there is a viable alternative. This alternative is known as a
collar.
▪ A traditional collar consists of buying a put for protection and funding
the cost of this protection by selling a call option. The result would be
protection against a downside move, but it would sacrifice profits if
there were a bullish move out of the underlying.
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7. Hedging with VIX Options
▪ Using VIX options as a collar would involve selling a put to fund a call. If
the collar is initiated to protect against a downside move in the overall
stock market, then the position should be set up to benefit from a rise
in the VIX. The long call should increase in value, while the short put
should lose value in a case of a rising VIX based on a drop in the market
▪ The hedging decision would start with an outlook for the overall stock
market. After establishing this outlook, the cost of VIX calls relative to
S&P 500 index put options hedging would need to be analyzed.
▪ There may be times when VIX calls are a favorable method for hedging
market exposure, especially in situations where a dramatic drop in the
overall market is feared.
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8. Hedging with VIX Futures
▪ VIX futures may also benefit from periods of equity market bearishness
and a subsequent rally in volatility.
▪ However, a consistent hedging program with front month VIX futures
contracts would be costly and the result would be a benefit in bearish
market environments, underperformance in bullish markets, and an
overall underperformance versus a pure long portfolio of stocks.
▪ This underperformance would be a result of how VIX futures contract
prices gravitate to the index over time.
▪ Using the front two month VIX futures as opposed to just the front
month contract will avoid this constant gravitation to the index by the
front month.
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9. Hedging with VIX Futures
▪ As the VIX and VIX futures have gone through periods of high
and low levels, an approach that dynamically hedges based on
some sort of indicator or market analysis may result in stronger
outperformance.
▪ This outperformance may be achieved through increasing and
decreasing exposure to volatility based on some systematic
approach.
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Monthly S&P 500 Index Returns Monthly VIX Futures Portfolio Returns

10. University of Massachusetts Study
▪ After the market turmoil of 2008, a study was conducted at the
University of Massachusetts–Amherst, to determine the potential
benefits of VIX futures and options as hedging vehicles.
▪ Two findings were determined by the study.
▪ First, in a period of dramatic market losses, such as this four-month
period in 2008, all financial assets tend to lose value, so a portfolio that
is considered diversified may not hold up as well as anticipated.
▪ The second finding involves the use of volatility as a diversification tool.
The result is that during a period of a market downturn, VIX
diversification results in protection. However, over the long term,
exposure to the VIX for diversification purposes may result in
underperformance.
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11. University of Massachusetts Study
▪ The growth of VIX option and futures contracts can be directly
attributed to the use of these instruments to hedge an equity
portfolio.
▪ A consistent program of hedging an equity portfolio with VIX
instruments can result in underperformance of a portfolio.
▪ When using VIX options or futures to hedge an equity portfolio
would result in cheaper protection that would result in strong
performance in the case of a dramatic loss in the equity market.
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12. Thanks