Investors use a variety of hedging strategies to provide downside protection. The right hedge for you and your portfolio depends on your trading style and risk tolerance. So, how do you choose?
If you’re like many investors, you become overwhelmed by all of the hedging options available (pun intended), so you default to not hedging at all.
Hedging involves a trade-off between risk and profitability. Determining how much risk you are willing to bear before a hedge kicks in is a personal preference. Do you want to hedge against a 10% drop or a 20% drop? Hedging against a 10% drop is more expensive than a 20% drop, so that particular decision will be a greater drag on performance.
There’s no perfect way to hedge. But, that doesn’t mean you should stop trying to protect your portfolio from market turmoil.
The VIX hedging strategy described here has two components: the first attempts to protect from short-term volatility spikes, and the second attempts to protect from tail-risk. Again, this type of strategy is one of many you could pick to hedge your portfolio. You can even automate your VIX hedging strategy.
Before we dive into the hedging strategy, we’ll start with a brief overview of the VIX.
What is the VIX?
The CBOE VIX index is a benchmark index where expected future volatility is calculated based on put and call option pricing in the S&P 500 index (SPX options). The VIX index is a 30-day representation of volatility expectations for the S&P 500.
Because volatility refers to the magnitude of price movements up or down, increases in the VIX indicate potentially high levels of price movement in the future.
The VIX is often referred to as a fear index because investors may buy VIX futures as a hedge against long stock positions, causing the VIX to increase in times of uncertainty. Therefore, the VIX is often used to measure investor anxiousness about the future.
High VIX index levels typically correspond with declining equity prices. Spikes are particularly noteworthy and used as an indication of a need to hedge. From a contrarian perspective, extreme readings on the VIX may indicate near-term or long-term bottoms in equity prices.
Now that we’ve laid the foundation, let’s dive into the strategy and case study.
This VIX hedging strategy consists of two components that, together, aim to protect from short-term volatility spikes and extreme tail-risk events.
What is the setup?
The VIX short call ladder involves selling an at-the-money VIX call and using the credit from the sale of the ATM call to purchase two out-of-the-money VIX calls with the same expiration.
Ideally, the “extra” call options are purchased inside the long leg of the first call spread to offer earlier protection from a volatility spike having a lower strike price. The target expiration for the short call ladder is 120 days.
The position is typically entered for a small credit or break-even, making it a costless hedge with defined risk. The initial risk on the trade is the difference between the short VIX call and the closest long VIX call times the number of spreads you might enter.
The “Doomsday Hedge” component is entered by going long the 0.10 delta VIX call options with approximately 120 days to expiration.
How does it work?
There’s a bit of nuance in management, but the concept is generally to remove the hedges in parts, just as it was added in two components, whenever volatility spikes occur.
In the example below, an $18 VIX strike call is sold, a $28 strike call is purchased (the inside leg), and a $30 strike call is purchased. The net cost of the trade is $0.00.
As shown in the payoff diagram below, if the VIX moves higher before expiration, the position’s value increases (the purple line). The higher the VIX moves in the near term, the higher the value of the hedge.
As expiration approaches, several scenarios exist. If volatility declines and the short call expires out-of-the-money, the short call ladder expires worthless, resulting in breakeven or a small profit if you entered the position for a credit. In our example above, the VIX would have to settle below the short call strike of $18 at expiration.
We like the short call ladder component of the VIX hedge because it gives you the opportunity to have a small hedge trade that protects the portfolio without the risk of paying for it if volatility doesn’t increase. If volatility doesn’t increase, we simply let the short call ladder position expire worthless. There was no harm done to the portfolio for this component, and we got all the benefit and upside protection against volatility without the cost included for the month.
Now, this, of course, doesn’t mean there isn’t risk in executing the hedge; there clearly is risk. But if volatility remains the same or goes down, you could have a costless hedge working for you.
If volatility increases, the amount of profit on the hedge depends on the timing and magnitude of the volatility spike. A sharp rise in volatility early in the life of the hedge may result in the highest profit potential, as the value of the two long calls rises faster than the value lost by the single short call that volatility is moving against.
The worst thing that could happen is for the VIX to rise slightly and settle right at or near our long call strikes, $28 and $30. At Option Alpha we lovingly refer to this as the “valley of death” because volatility increased, but not enough, or not early enough, to realize a profit on the hedge. This is the risk associated with this component of the hedge.
Now for the second component of the hedge. The 0.10 delta VIX “Doomsday” call options profit from a Black Swan-type event. The likelihood of the “Doomsday” options profiting is low because they are meant to hedge against extreme tail-risk events. If volatility increases by multiple standard deviations, then the profit potential from the “Doomsday” calls is theoretically unlimited. This is your “the world is blowing up and collapsing” insurance against the unknown events (Black Swans) that occur.
What is the risk?
As we briefly mentioned earlier, the maximum risk on the trade occurs if the VIX rallies slightly and expires near or between the long strikes. This creates the highest risk between both components of the VIX hedge.
To understand the total risk for the hedge, we need to calculate the maximum risk of each of the two components.
To calculate the risk of the short call ladder, subtract the spread width between the short call option and the closest long call option. For example, in the payoff diagram above, the width between the $18 and $28 strikes is $10 ($1,000). If opening the position resulted in a small credit, you would subtract the credit collected from the spread width.
We use the inside long call option to calculate risk and not use the $30 strike calls. Why? If volatility explodes, the $28 strike call options kick in sooner and hedge the upside volatility risk.
The maximum risk of the “Doomsday” portion of the hedge is the cost of the long call options. For example, if you purchase four calls at $0.40 each, the maximum risk is $160.
So then, the maximum risk on the combined hedge is the maximum risk of the short call ladder plus the cost of the “Doomsday” hedge.
How much should I allocate?
Naturally, you should be the final judge of your own portfolio and allocations for trading. Remember, this VIX hedge does incur a cost to the portfolio when executed continuously. Insurance costs money to offer valuable protection, and this is no different.
Therefore, we believe a very small allocation target for the combined position could start around 0.25% each month. The recurring, laddered monthly entries build a hedge with approximately 1% overall allocation.
VIX Hedge Case Study: Late 2019 to Early 2020
Let’s take a look at a real-world example that illustrates the value of this hedging strategy. Leading up to the Pandemic Crash of February 2020, markets were calm. The VIX hedge would have expired worthless for many months, and hedging may have seemed unnecessary. However, we had been consistently deploying this strategy for months. This is why.
First Laddered Entry
On November 19, 2019, the S&P closed near all-time highs, and we entered a new round of laddered entries for the VIX hedging strategy.
The hedge consisted of two trades: a VIX short call ladder and the VIX call “Doomsday Hedge.”
We added the short call ladder with 18 MAR 2020 expiration for a net credit of $0.05:
- -1 Short 11 strike call
- +1 Long 15 strike call
- +1 Long 17 strike call
The goal of the trade was to add long volatility exposure for little or no cost. In this case, the position was filled for a small credit which means we were paid to enter this side of the hedge, albeit a small amount.
The risk for a single spread was $395. To calculate the maximum risk, subtract the spread width of the closest call options ($11 and $15), Then, subtract the credit collected ($0.05) from the spread width ($4.00) for $3.95 of risk.
Remember, we use the innermost long call option to calculate risk and not use the $17 strike calls. Because if volatility explodes, the $15 strike call options kick in sooner and hedge the upside volatility risk.
The trade’s maximum risk would occur if the VIX rallied slightly and expired near the long strikes. For example, if the VIX closed at $15 on expiration, the short call is in-the-money by $5, and the long options expire worthless for a loss of -$395.
Remember, if the VIX had stayed low, then the hedge was cost-less. In case the VIX moved higher, we set up a 1.5x profit-taking level for the long strikes. We entered good-til-canceled (GTC) orders at 1.5x the entry price for the center, long strike of the call ladders.
The allocation target for the position was less than 0.25% because of the laddered, monthly approach to building the hedge we mentioned earlier.
For this hedge trade, 0.25% of risk was $750, and the $395 risk from the first component of the hedge left $355 of capital for the “Doomsday” component.
We added the “Doomsday” component on the same day. We bought 4 VIX calls with a $40 strike and 18 MAR 20 expiration for a $0.40 debit each. These were 0.10 delta call options near 120 days to expiration. The second component represented cheap protection from massive tail risk. The 4 contracts at $0.40 each added $160 of risk, bringing the total risk on this ladder of the hedge to $555, or less than 0.20% of capital.
A few days later, on November 26, 2019, we added to the “Doomsday Hedge” by purchasing 15 $45 strike VIX calls for 18 MAR 20 expiration at $0.25 each. This additional purchase ($375 of capital risked) brought the total hedge allocation up to the full amount for the laddered entry but still less than 1% of the portfolio.
Second Laddered Entry
On December 19, 2019, the S&P again closed at new highs, and we added another laddered entry to the VIX hedging strategy, adding another full round of hedge components.
We added the short call ladder with 15 APR 2020 expiration for a net credit of $0.30:
- -1 Short 10 strike call
- +1 Long 14 strike call
- +1 Long 16 strike call
The risk for a single spread was $370. To calculate the risk, subtract the spread width of the closest call options ($14 and $10) and then subtract the credit collected ($0.30) from the spread width ($4.00) for $3.70 of risk.
The maximum risk on the trade would occur if the VIX rallied slightly and expired near the long strikes between $14 and $16.
If the VIX stayed low, then the hedge was cost-less; actually, we would have been paid a small credit. Following the same process as we did on the first laddered entry, we set a profit-taking GTC limit order at 1.5x the entry price on the inside long call ($14 strike) if the VIX moved higher.
The allocation target for the position was less than 0.25% because of the laddered, monthly approach to building the hedge. The $370 for the short call spread component of the hedge left $380 of capital for the “Doomsday” component.
We added the second “Doomsday” component of the hedge on the same day. We bought 10 VIX calls with a $40 strike and 15 APR 20 expiration for a $0.35 debit each. These were the standard 0.10 delta VIX call options near 120 days to expiration.
The second component represented cheap protection from massive tail risk and was the same contract as previously added on November 19. The 10 contracts at $0.35 each added $350 of risk, bringing the total risk on this ladder of the hedge to $720 or 0.25% of capital.
Our total hedge between the two ladders was now around 0.50% of the portfolio.
Third Laddered Entry
On January 24, 2020, the S&P was near highs, and just over a month had passed since the second laddered entry in the VIX hedge.
For the third month in a row, we added a short call ladder and the standard, long 0.10 delta calls for another round of hedge building for our portfolio.
We added a short call ladder with 20 MAY 2020 expiration for a net credit of $0.15:
- -1 Short 12 strike call
- +1 Long 16 strike call
- +1 Long 17 strike call
We added long volatility exposure for a small credit while keeping the risk on the position low.
The risk for a single spread was $385. Again, to calculate the risk, subtract the spread width of the closest call options ($16 and $12) and then subtract the credit collected ($0.15) from the spread width ($4.00) for $3.85 of risk.
Staying consistent, we set a GTC limit order for the long $16 strikes at 1.5x the entry price as a profit-taking level.
The allocation target for the position was less than 0.25% because of the laddered, monthly approach to building the hedge. $385 of risk for the first component of the hedge left $365 of capital for the “Doomsday” component.
We added the second “Doomsday” component of the hedge on the same day. We bought 10 VIX calls with a $35 strike and 20 MAY 20 expiration for a $0.35 debit each. These were the standard 0.10 delta call options near 120 days to expiration. The 10 contracts at $0.35 each added $350 of risk, bringing the total risk on this ladder of the hedge to $735 or approximately 0.25% of capital.
Our total hedge was now around 0.75% of capital.
Pandemic Starts, Markets Crash
On February 25, 2020, the market began to drop as COVID-19 fears spread quickly and the global pandemic accelerated.
After four straight down days, the market approached correction territory, and we considered exiting the trade early for a profit. When we entered each of the laddered hedges, we set a 1.5x profit-taking level on the long strikes of the short call ladders.
- VIX 20 MAY 20 Long 16 call = GTC order set at 6.25
- VIX 15 APR 20 Long 14 call = GTC order set at 10.00
- VIX 18 MAR 20 Long 15 call = GTC order set at 9.60
If the limit orders triggered, we would close the long inside leg of each short call ladder and keep the short spread open to potentially profit from a subsequent decline in volatility. If volatility did not decline, the remaining short spread would potentially expire in-the-money, and the contracts would offset, settling for cash at expiration.
We did not set profit targets for the “Doomsday Hedge” because those contracts were in place for extreme volatility and a worst-case scenario.
Clearly, we had no idea the market collapse would accelerate so quickly as you are about to see from the follow-up actions a few days later. Volatility and hedging are never an exact science because no two volatility events are the same.
It’s okay to be discretionary with your exits. The goal is to have the opportunity to manage the hedge, which requires it being consistently entered before spikes in volatility.
The First Profit-Taking Order Filled
On February 27, 2020, the first GTC profit-taking order was filled soon after the market opened. We sold the $15 strike inside leg of the 18 MAR 20 short call ladder for $9.60. This sale represented a 1.5x profit on the leg and left the remaining call spread for March ($11 and $17 strikes).
Volatility Jumps and Orders Get Filled
Volatility continued higher. Stock futures pointed to significant losses. So, before the market opened on February 28, 2020, we removed the GTC profit-taking orders from all three short call ladders in case the market opened lower and continued to move lower.
After the market opened, we closed some of the VIX “Doomsday Hedges.” We closed the near-dated contracts first, the 18 MAR 20 expiration, selling the $40 calls at $1.55 (originally purchased for $0.40 on November 19). We closed the in-the-money calls first because the value could disappear if volatility faded, so we removed a layer and took the profit.
About 30 minutes later, we sold the other set of March long calls ($45 strike purchased on November 26 for $0.25) closest to expiration for $0.95 to realize another profit on the hedge.
At the same time, we sold the $14 strike inside leg of the 15 APR 20 short call ladder for $11.10, significantly more than the initial GTC order of $10.00. That left the in-the-money VIX call spread for April (the remaining $10 and $16 strikes).
Around the middle of the trading day, we closed the $16 strike inside leg of the 20 MAY 20 short call ladder for $6.70 (compared to the initial $6.25 GTC profit-taking order), leaving the May call spread ($12 and $17 strikes).
At this point, and with just as limited visibility into the future as any other trader, we decided to walk away from the majority of the hedge with profits in hand. Clearly, hindsight is 20/20 when trading and investing, but we felt comfortable removing a good majority of the hedge just beyond initial profit targets. By the end of the day, the $40 strike April and $35 strike May “Doomsday Hedge” VIX calls remained in place to protect the portfolio from further volatility.
Volatility Persists and Hedge Profits Climb
On March 9, 2020, the market sell-off continued, with the correction nearing a 20% drop. First, we started kicking ourselves for not holding on slightly longer to some of our hedges. But, this hindsight self-destruction is not helpful, so we quickly moved on and started managing our positions.
That day we closed all 10 of the 15 APR 20 expiration $40 VIX calls for $4.60. Remember, these were purchased for $0.35 on December 19, 2020. With only 36 days until expiration, these calls would have gone down in value unless volatility continued to stay high or moved higher.
With a significant profit on the hedging strategy and the remainder of the portfolio risk-defined, this layer of the hedge had done its job, helping the portfolio weather one of the fastest market declines in history.
Closing the Final Hedge
By March 12, 2020, only a few weeks removed from all-time highs, the S&P was down over 25%.
We sold the last set of May expiration “Doomsday Hedge” calls for a massive profit. We sold the 10 $35 calls for 20 MAY 20 expiration purchased for $0.35 on January 24 for $6.50. This represented an over 18x return on this final layer of the hedge.
It seemed unrealistic for volatility to stay so elevated through May, and the hedge had done what it was intended to do. At the time, we felt that we were edging too close to a massive reversal and bounce in equities.
Hedge In Review
It’s always important to pause and look back on significant trading events like the Pandemic Crash and review some of the most important takeaways, things we could have done better, and what we learned.
- First, it’s important to note that we did not have a crystal ball that told us to prepare for this particular Black Swan event or that it would come so quickly after starting to execute the hedge. However, a thorough study of market history shows these events happen more frequently than a normal distribution implies. We didn't know when or how it would happen. We just wanted to be prepared when it did and certainly got lucky with timing.
- We knew correlations tend to break down and converge (autocorrelation research) during volatility events, so diversification alone wouldn’t protect our portfolio, and this crash was no different. All markets started moving together just as they had done in previous crashes, which meant that we needed an uncorrelated tail hedge against broad volatility.
- The combination of risk-defined positions, an overall low allocation (less than 50% of portfolio capital), and the VIX hedge did incredibly well during the sell-off. As we see it here, the goal with hedging is to avoid fatal “knockout punches” from market crashes. We’re more than happy with the overall performance.
- Adjusting positions helps mitigate losses when the market moves against a position, but adjustments alone do not offset losses during a significant market event. In this case, a conservative cash position and the VIX hedge were a potent combination to deal with market volatility. It’s probably a great habit to curb position sizes when markets are high and volatility remains persistently low. Nothing remains constant, and markets cannot go up (or down) forever. They ebb and flow, and our portfolios should account for this tilting that occurs.
Perhaps we sold the inside leg of the short call ladder too early. Maybe we sold parts of the “Doomsday Hedge” too early. Those are management decisions that must be made in real-time and are hard to quantify beforehand.
However, the main point to emphasize is that having the hedge on before the market event was the important piece of the puzzle. You don’t have the opportunity to make the management decisions if you didn’t have the hedge on to begin with. As the saying goes, “Don’t try to catch a falling knife.”
The VIX hedge was certainly effective during the Pandemic Crash. Would the hedge work with today’s pricing? As markets change, strategies have to adapt, too.
The short call ladder idea may still be viable, although pricing today requires a much wider short call ladder causing the maximum risk for the position to be higher than with the case study.
For example, the maximum risk in the example at the beginning of this article was $1,000 compared to the maximum risk for each of the short call ladders in the case study of less than $400.
Today’s pricing on the “Doomsday Hedge” makes it impractical. The cost is astronomical compared to the last two years. It's not just that the dollar cost of the hedge is up astronomically, although it is a good bit higher. It's that the same 120-day, 0.10 delta calls on the VIX now have $80 strikes compared to $35 and $40 strikes in the case study.
Just because the hedge’s pricing is not optimal today doesn’t mean the trade won’t be practical in the future.
So what is a trader to do? If this hedging strategy fits your market outlook and risk tolerance, watch the pricing of laddered entries and continue to familiarize yourself with the P&L diagram under various volatility scenarios while looking for cheaper, more cost-effective entries. If this hedging strategy is not for you, keep searching! There are other hedging approaches to explore. Protecting your portfolio from market declines is just as important as profiting from market opportunities that align with your strategy.