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« March 2015

IVolatility Trading Digest™ Blog

Volume 15 Issue 9
VIX Hedge Plan [Charts]

VIX Hedge Plan [Charts] - IVolatility Trading Digest™

Trade selection using volatility as the primary criteria. Different trades for different volatility opportunities.
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As macro concerns from Europe relating to both Greece and Ukraine faded into the background last week, the S&P 500 Index advanced to a new closing high Wednesday after Federal Reserve Chair Janet Yellen said "patient" remains the key in deciding when to start raising the key interest rate. Then equities turned lower in what seems to be a normal retest of the previous highs. However, since the nonfarm employment report for February is due Friday it could add downward pressure on equities unless the seasonal weather adjustment accurately reflects the abnormally cold and snowy conditions in the Northeast and Midwest during February.

After our market review, we have a hedge suggestion in the event the retest of the breakout now underway continues beyond support using CBOE Volatility Index® (VIX) options.

Review NotesS&P 500 Index (SPX) 2104.50 following the new 2113.86 closing high Wednesday in a narrow trading range, it began the normal process of retesting the breakout above the previous highs made both February 14 and 15. The next support is the December 29 high of 2093.55 that will likely contain the decline. The upward sloping trendline from the October 15 low now crosses at 2025, while the three point intermediate term upward sloping trendline from the November 16, 2012 low of 1343.55 crosses at 1920.37 10.71 about 184 points or 8.75% lower.

CBOE Volatility Index® (VIX) 13.34 declining volatility was underway before the Federal Reserve stressed patience before hiking interest rates and now appears headed for a test of the 12.50 area reached in November and December.

The table below shows the VIX cash compared to the next two futures contracts as well as our calculation of Larry McMillan’s day-weighted average between the first and second months.


The day weighting applies 60% to March and 40% to April for a 23.19% premium shown above. Our alternative volume-weighted average between March and April, regularly found in the Options Data Analysis section on our homepage, is slightly lower at 22.83%. Premiums for a normal term structure are 10% to 20%, while premiums above 20% are unsustainable suggesting a lack of enthusiasm for VIX hedging. Alternatively, premiums less than 10% suggest caution and negative premiums indicate an oversold condition. Last week the premium began at 18.77% and exceeded 20% on Tuesday and Wednesday as well as Friday’s high of 22.83%. In the past premiums in excess of 20%, suggested an overbought condition preceding pullbacks.

VIX Options

With a current 30-day Historical Volatility of 117.02 and 101.46 using Parkinson’s range method, and rapidly declining, the table below shows the Implied Volatility (IV) of the at-the-money VIX calls and puts using the futures prices based upon Friday’s closing option mid prices along with their respective month’s futures prices, since the options are priced from the tradable futures.


The implied volatility index was 76.80 and declining so compared to the current range historical volatility of 101.46, also declining, both the March and April options appear inexpensive however, puts with limited downside may still attract selling in combination with long calls as a hedge like the suggestions below.

Here is the CBOE Volatility Index® (VIX) chart showing the expected lower limit at 12.50.


With the downside somewhat limited to the previous lows selling a put and using the proceeds to purchase a call offers a low cost opportunity to hedge an expected market decline that may result from a disappointing nonfarm payroll report Friday.

First, here is the volatility chart for the last year showing declining implied and historical volatility.


Since the options are relatively inexpensive compared to the recent movement of the VIX, here are two hedging examples, one using March options the other April options.


Using the ask price for the purchase and the bid for the sale results in a .05 credit while the delta is 1.00 and Vega, the time decay is mostly offset.


The underlying future contract for at-the-money April options are 17s while March are the 16s. See the VIX Options table above. Once again, using the ask price for the purchase and the bid for the sale results in a .50 debit while the delta is 1.00 and Vega, the time decay is mostly offset. Other than one resulting in a credit while the other is a debit, the most significant difference is the Gamma or the rate of change of delta at .13 for March and .08 for April. While providing more time, April is less sensitive to changing VIX futures prices.


CBOE S&P 500 Skew Index (SKEW) 126.40 measures the purchase of out-of-the-money S&P 500 Index puts that require a very large downside move to profit from long put positions. An increase of this index indicates greater expectations for an extreme down move. The CBOE explains further, a Skew value of 100 means the perceived distribution of S&P 500 log-returns is normal so the probability of outlier returns is negligible. As Skew rises above 100, the left tail of the distribution acquires more weight increasing the probability of outlier returns.

Once again, SKEW remained in range between the Wednesday high of 136.33 and the Thursday low of 126.20 suggesting any enthusiasm for purchasing out-of-the-money S&P 500 Index puts Tuesday and Wednesday before Janet Yellen’s testimony diminished Thursday . The best signals are at the extremes so the current reading just below the current range midpoint of 128.70 provides little useful information about increased put buying.

Market Breadth

For the week, the McClellan Oscillator Summation Index of market breadth reported by McClellan Financial Publications closed at 3041.51 advancing every day last week for another 272.36 gain as breadth continues improving.

US Dollar Index (DX) 95.29 is now in a range between 94 and the high of 95.48 made January 23. The two operative trendlines are from the October 15 low at 84.47 to the December 16 low at 87.63 for the first while the nearest begins at the December 16 low and touches the lows of 91.51 on January 15 and 92.15 on January 21. While the nearest has been broken as DX traded sideways in a range the lower more important now crosses down about 91.75. Interestingly the dollar index stalled as the advance in crude oil gained momentum suggesting crude oil prices may be the current driving force.


strategyFactset reports 485 of the S&P 500 Index companies have reported 4Q earnings with 76% reporting above the mean estimates. There had been concern that the stronger dollar would reduce earnings for many large capitalization stocks with international operations but now the focus will shift away from earnings reports to the next nonfarm payroll report due Friday. Seasonally March and April are good months for equities and after retesting the recent breakout, the S&P 500 Index is likely to continue higher. However, just in case the important employment report disappoints and the pull back becomes something more severe some hedging may prudent. Using inexpensive VIX options is one alternative strategy and like disaster insurance, it cost less when not obviously needed.

The suggestions above uses closing ask prices for the buy and bid prices for the sell. Monday’s option prices will be somewhat different due to the time decay over the weekend and any stock price change.


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As 4Q earnings reporting wraps up, the S&P 500 Index made another new high and then turned slightly lower to retest the recent breakout. Although seasonally favorable for equities, those who may think valuations seem stretched any disappointment from the upcoming nonfarm employment report could provide justification for a push below current support levels. Accordingly, an inexpensive hedge strategy could be prudent.


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Fascinating commentary on the VIX trade but there is one comment I don't understand: " while premiums above 20% are unsustainable suggesting a lack of enthusiasm for VIX hedging. Alternatively, premiums less than 10% suggest caution and negative premiums indicate an oversold condition." Can you explain the logic here?

Posted by Peter Roan on March 02, 2015 at 01:39 PM EST

Peter, Thanks for the comment and question. Since the realized volatility (historical volatility) of the VIX is considerably higher than the realized volatility of S&P 500 Index, portfolio managers with large equity exposure, let’s call them professional hedgers use VIX options that are priced from the futures. By measuring the amount of additional premium they are willing to pay over the cash value, we determine their level of concern for an immediate decline in the SPX since at expiration the futures equal the cash. While the VIX futures increase as the VIX increases, the spread between the cash and the futures will narrow during times of increasing hedging demand as futures prices are bid higher closing the spread. The width of the spread gives us information about the current market condition. If the spread between the VIX cash and futures is “normally” 10-15% but then declines to 1% or even turns negative, it reflects increasing prices for the futures. As an indication fear is diminishing, watch for a quick return to the normal range suggesting complacency, or less of enthusiasm for hedging as the futures declines relative to the cash, and the spread increases. VIX premiums act contrarily, much like other sentiment indicators. When there is little interest in hedging the premiums increase in value as the distance between future and cash increases. Since they are unlikely to remain above 20% for long, it suggests a pull back is likely. Alternatively, as the futures are bid higher on more hedging demand, the spread narrows and the premiums decline and finally when they go negative it suggests the S&P 500 Index is oversold and due for a bounce. The mid-range with premiums between 10% - 15% suggests a neutral condition. Like other sentiment indicators, useful information is at the extremes. Based upon observation, it seems higher readings correspond to market tops while low and especially negative readings correspond to market turns after pull backs. Jack

Posted by on March 02, 2015 at 07:09 PM EST

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