I’m hedging my stocks by going long volatility

By Prieur du Plessis, on January 21st, 2011 posted in: Investment, Stocks 8 people had their say - chime in!

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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 15.5 on December 22 and January 14 before climbing by 15.0% to 18.0 over the past three days. 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 bull market is looking tired, on top of the fact that stocks are overloved, overbought and overvalued. (Also see my post of yesterday, entitled “Stock markets – two canaries calling for caution”.) 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: “On seeing some downside key day reversals in European indices yesterday and with a number of leading Western stock market indices looking temporarily overextended following their uptrend extensions over the last seven weeks, plus every financial TV commentator saying “buy Wall Street”, I opened shorts in the Nasdaq 100 Index and the S&P 500 Index … I am not looking for more than a short-term reaction and some mean reversion towards the medium-term uptrend represented by the 200-day moving average.”

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. As I am pre-empting an upside break of the VIX, I have protected my position with a fairly tight stop.

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

Source: StockCharts.com

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