Hedging with Volatility Products
My column in TheStreet.com on hedging with volatility products;
How to Protect Your Portfolio From Stock Market Turbulence
NEW YORK (TheStreet) — Volatility in the stock market is what makes investors nervous. Not all volatility is bad, though, for without volatility stock prices would never rise. Volatility is typically measured as the standard deviation of returns for a particular stock or market index. It’s downward volatility of the market that causes fear and panic.
The CBOE Volatility Index, or VIX, is often referred to as the “fear index.” The VIX is calculated from the implied volatility of options on the S&P 500 index. When fear is high, the implied volatility can rise rapidly, causing the value of the VIX to spike.
The VIX has been around since 1993, and according to the CBOE it is considered to be the world’s premier measure of investor sentiment. VIX futures have been trading since 2004, and options were introduced in 2006. The introduction of futures and options on the VIX has given investors a good way to trade volatility and use it as a tool for hedging risk.
Recently, the explosion of exchange-traded funds has led to the creation of several volatility-based ETFs, making trading volatility easier than ever before. According to the ETF Database, there are several different volatility ETFs available today, including short-term, midterm, leveraged and inverse.
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There have been numerous studies done on using the VIX to hedge equity portfolios. Goldman Sachs did one that concluded that VIX options could be a very effective portfolio management tool for risk reduction.
Today with all of the volatility-based ETFs available, investors who want to do some hedging can use an ETF, VIX options or an options strategy with one of the ETFs.
One thing you can do is to simply purchase the ETF and hold it until the VIX increases or the time frame during which you want to hedge your portfolio has passed. Holding the ETF long term may not work as well as you’d like, however. The funds consist of futures contracts that are rolled over as they expire, and there will be some time decay. If the stock market is rising and volatility is falling, the ETF can lose so much value that it will no longer be effective as a hedge over a long period.