How to use a volatility Call Spread as a Downside Hedge?

on Mar 22, 2015 in Derivative, Equity, Home | 2,901 comments

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One way to hedge the downside risk in your portfolio over the following three months is to purchase some put options. The exchange-traded fund SPY tracks the S&P 500 index, is highly liquid and makes a nice proxy for your US equity holdings. If you purchase the adequate out-of-the-money puts on SPY to hedge against a 10% market decline for your entire portfolio, you’ll pay about 3% of portfolio value.
It is only under the condition that the market slumps more than 13% (10% decline plus 3% cost for the put premiums), that you have put a floor under which the portfolio is covered. Is that actually the best strategy to play?

The call spread option trading strategy on the CBOE Options Volatility Index (VIX) might be the solution. In my view, this could be an interesting indirect theme to play.
Remember, if the market goes down the VIX will go up. And if the market really pukes, the VIX will roar higher.
Bull call spreads can be implemented by buying an at-the-money call option while simultaneously writing a higher striking out-of-the-money call option of the same underlying and the same expiration month.
By shorting the out-of-the-money call, you reduce the cost of establishing the bullish position but forgoes the chance of making a large profit in the event that the volatility skyrockets.

As the market continues to shoot to all-time highs, this strategy would act as a complementary trade to your portfolio since volatility typically expands when the market sells off.
Higher volatility means higher options prices as larger swings are expected. Low volatility means little is expected in the way of market movement which is why I often think of the VIX as an indicator of relative market stress. Some people call the VIX the Fear Index as volatility tends to explode in falling markets and drop in rising markets.

Currently the VIX is trading at 14.07. Its 52 week range is 10.28 – 31.06 and this indicates to me that there is still a relatively high level of complacency in the market despite the global economic uncertainty and equity markets shooting to all times highs. Keep in mind that at the height of the financial panic in 2009 it touched 80.

Let’s look at the VIX April contract 16-20 call spread. This spread is trading at 0.85, which seems cheap to me. A VIX at 20 or higher will more than triple your investment. That means that if the VIX is over 20 in the following month (not at all unlikely, and under the 52-week high) the spread will expire at four. So, you are risking less than one to make more than three, I consider it to be a highly favorable risk/reward ratio in this market environment.

This strategy could be a way to hedge your equity portfolio against a major move lower, albeit perhaps indirectly.