One thing that you never want to do with any protective strategies is expose yourself to even more risk through your hedges. This may sound simplistic and obvious, but it is not.
I once discussed the use of VIX options as a hedge against a short volatility position in the form of short S&P 500 calls and puts. This can be a great place to use the VIX, as there is a direct relationship between the index and SPX volatility.
But what if you just want to sell puts in the VIX? That was once suggested by an acquaintance of mine who is a Ph.D risk director for a hedge fund.
It is true that those VIX puts would lose money if the S&P 500 fell and the VIX rose, creating a profit for the "hedge." However, the real concern for a short volatility position is the proverbial " fat tail " or " black swan " in which there is huge drop in the S&P 500 and a corresponding spike in the VIX, as we saw in 2008.
In those cases, the "hedge" of a short VIX put would run out very quickly because all that can be made on such a position is the premium from the option sale. And far more damaging can be the risks involved in this so-called protective strategy.
The VIX does have a lower bound around 9 percent, so it will never go to zero. But the VIX options are priced off the VIX futures, which usually carry premiums. That, coupled with the fact that the VIX can drop sharply, means that naked put selling carries a huge amount of risk in and of itself.
Another example of this can be seen in gold and silver, which are often viewed as hedges on long equities. Owning these precious metals can provide protection, but not always.
For example, the SPDR Gold Shares Fund (GLD) and the SPDR S&P 500 Fund (SPY) fell in unison last September, December, and May, when the correlation between the two went up to essentially 1. The iShares Silver Fund (SLV) has seen similar moves.
The wild card here is that the metals often react to more than just moves in the stock market, such as inflationary issues and industrial demand. That can expose such hedging strategies to huge losses, regardless what the SPX does.
One way of getting around this is to diversify your strategy, as opposed to assets. (If asset correlation can go to 1, then that isn't really diversifying your portfolio.)
Ray Dalio, head of the largest hedge fund Bridgewater Associates, has suggested that this is the only true diversification. But most of us don't have access to such sophisticated institutional tactics as merger arbitrage, statistical arbitrage, or other strategies that are even more complicated.
That's when we turn to options. Using vertical spreads or butterflies instead of direct equity positions reduces risks greatly. That can be done with gold, silver, bonds, and even volatility.
So instead of having 20 stock positions, it may make more sense to have some equity calls or call spreads and diversify them with similar option strategies in non-correlated assets. Call spreads in the GLD, SLV, or VIX can provide adequate protection while reducing costs and limiting risk.
(A version of this article appeared in optionMONSTER's Education Newsletter of Sept. 5.)
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