I've been shorting VIX futures, but one thing that has become apparent to me is that I'm pretty exposed to tail risk events. For instance, when 9/11 happened, the markets were shut down for nearly a week and the VIX jumped from 31.84 on 9/10 to 41.76 on 9/17, a move of 9.92 points, or more than 31%. While the VIX dropped back into the low 30s within a week or two, this "overnight" pop would clearly wreak havoc with VIX futures since they are marked to market daily. I'm looking for a hedge that will "eliminate" this uncontrolled risk. It doesn't need to be a perfect hedge -- I'm OK accepting a loss when a black swan happens, but I'd like to avoid a total wipeout. I've looked at VIX options both as a replacement to VIX futures (e.g., sell ITM puts to short the VIX, so max loss = option premium) and as a hedge (buy VIX calls as "insurance"), but because the VIX is so mean reverting, it isn't clear that these actually provide both the profit potential of VIX futures or the best hedging protection (VIX futures don't react the same way to VIX volatility as equity options do to standard volatility). I've read various papers about using ES futures to hedge, but the context of most of those papers is hedging versus "standard" events, where the VIX is driven by a market correction, not by an exogenous event (e.g., terrorism, Iran nukes Israel, etc.). Note that if the event takes a day or two to play out, that's typically fine. I'm worried about going to sleep one night and then waking up with a massive problem. And yes, I could reduce my trading size, but that obviously reduces my profit substantially (and it's not even clear how much to reduce it by since a black swan event is by definition bigger than anything you might imagine). So, ET gurus, what are your thoughts? Thanks for any suggestions.
At first, I thought that was true, but look at the data from 9/11. It was a 9.92 point VIX shock (31%), but the SP500 only went from 1092 on Sept 10 to 1038 on Sept 17 (about 5%). Effectively, the markets got really, really scared (VIX jumps 30%), but the actual correction from it, while certainly large (5% in one day), was not what I would consider a black swan. I could load up on SPX puts or something, but it seems like the protection required might be lots and lots. Right now, the only thing I can think of might be buying far OTM calls on VIX ETFs (e.g., UVXY). Does anybody know if those react in price more similar to standard equity options? The problem with raw VIX options is that they are European style and can't be exercised early. Since the VIX is so mean reverting, they move far less in price during a shock because everybody expects the VIX to correct rather quickly and they can't be exercised in the mean time. They might protect you against a fast-moving megastorm like the 2008/2009 global financial crisis that comes on somewhat quickly and then takes months play out, but I don't think they would protect you against an "instantaneous" black swan associated with VIX spikes. VIX ETF options are American style, so I assume that they would react more since people could exercise them immediately and that would create an arbitrage opportunity if they didn't.
European vs American options don't affect the price change of the option in the scenarios you are talking about. The best hedge to an event is to not be short futures. The pnl you are making being short is the insurance premium your counterparty is paying to be protected in that event.
Hmm... OK. Gotta do more reading about Euro vs. American options then. It was my understanding that VIX options didn't behave the same as you might expect standard options to expect during VIX spikes because of the combination of the mean-reverting character of the VIX, coupled with Euro style option exercise. Effectively, the option is a bet on the final VIX value at expiration, so the spike in VIX can't be capitalized on during the interim. Thus, because the VIX is highly mean reverting, the movement in the VIX is highly discounted. But maybe I have that wrong. So, yes, VIX futures are heavily used themselves to hedge against market downturns and I'm trying to take the risk premium by going short. Effectively, what I'm looking for is re-insurance for catastrophic scenarios.
The VIX options pnl can be monetized (by selling the option or hedging with futures). European and American only have to do with expiry. You can "lock-in" your gains in both the same way. VIX options don't behave like other options but that is because the VIX doesn't behave like other underlyings.
It's always going to be expensive to buy VIX options; maybe they were cheap in 2006 but not since. There is nothing wrong with shorting VIX futures, as long as you bear a couple of things in mind: First diversification. If VIX is only a small part of your portfolio, then the damage from a big overnight move is limited. I have 5% in VIX and 5% in V2X. More would scare me. Your overall capital risk should be able to cope with a 2008 size move in 10% of your portfolio. Secondly, rather than buy options, buy synthetic options. If you trend follow VIX that is like owning a synthetic straddle. When the price jumps, you'll automatically reduce your position, and eventually go long. This won't protect you from overnight jumps.
Thanks, globalarbtrader. Agreed on diversification, but I don't want to size my portfolio for the black swan worst case, either. Honestly, if you do that, you shouldn't be trading at all. The key here is to avoid a wipeout (survive to trade out of the resulting hole) for an overnight, weekend, or huge instantaneous VIX gap that might occur during the day. If the markets just get a little more volatile, that's not an issue for me. It's the instantaneous stuff that I worry about (e.g., 10 point VIX jumps). What do you mean by "synthetic options?" If you could describe the mechanics, that would help. You don't mean a synthetic position using options, do you?
Do what NT does for black swan events. Take no risk and take enormous risk at the same time. In other words, buy tbills and use the interest income to buy OTM puts and calls.
I was talking about avoiding a 2008 event (or a 1998, or a 1987 event for that matter). I don't know whether a once in 10 year event qualifies as 'black swan' but I'd certainly be concerned if I knew I was likely to blow up every 10 years. A synthetic option (my definition) is where you trade the underlying to create an option like payoff (so the reverse of creating a synthetic position using options). A good example of this was portfolio insurance in the late 1980's. Suppose you want to create a synthetic put on the March 2015 S&P 500, with a strike of say 1900. You calculate the delta of that option and then sell enough futures to match that exposure. Repeat as the price moves and the expiry gets closer. Pros of synthetic options: you pay realised vol, not implied vol. When OTM implied vol is expensive because of smile this can make sense. OTM option spreads are often wide. Cons: You're exposed to jump risk (a problem more for those selling synthetic vol). You pay transaction costs (although these can be reduced with appropriate techniques). Its a lot more work. Trading a trend following strategy gives you something, but not exactly the same, as holding a synthetic at the money straddle. The problem with NT's strategy is that you are giving up performance for positive skew, because you're paying for the impled vol premium, the OTM smile, and the wide spreads. Trend following allows you to get the positive skew with hopefully less performance drag.