Hedging the inverse volatily ETPs with calls

Discussion in 'Options' started by stevenpaul, Nov 7, 2017.

  1. The inverse volatility market certainly seems fragile, with the potential for a catastrophic volatility spike looming in the offing at all times.

    What can we do to make XIV and its ilk a little more robust? I am exploring OTM calls in VXX and VIX. (SVXY options are rather illiquid by comparison.)

    What percentage of the inverse vol market value should be allocated for such an option position? And what is the best delta for the options?

    There have been studies on hedging the S&P with VIX options, and it looks like the best ratio is a 97% allocation to the S&P and 3% allocation in VIX options, OTM by 25%. Source:

    https://etfdailynews.com/2012/05/30...ortfolio-hedge-spy-tvix-vxz-vxx-vqt-tviz-xvz/

    However, we're not interested in hedging the S&P. We are trying to hedge the inverse volatility products with calls in the vol markets. Should the option allocation and moneyness resemble the ideal hedge for the S&P, or is it something entirely different?

    I would guess that a greater allocation than a mere 3% would be necessary, due to the severity of the spikes, when they occur. A small allocation may be insufficient to compensate for the drawdown in the primary market, the inverse ETP. Perhaps around 5% may be necessary. I can imagine how the 25% OTM value of the calls is about right, as a good vol spike could easily bring the market right up to those levels and beyond.

    The next question is whether the contango factory produces enough gains in the ETPs to offset the call premium. With IV deflated as it is, this seems about the right time to hedge with calls.

    Whoever is interested in this topic, please weigh in.
     
  2. truetype

    truetype

    SVXY options are quite liquid. Try bidding inside the spread.
     
    stevenpaul likes this.
  3. A favoured structure for cost-efficient hedging against VIX spikes has been short 1 x 2 call spreads (backspread), with the short strike set slightly OTM and the long calls 3-5 handles above. It's an actively managed hedge: typically users establish it ~ 60 DTE and roll ~ 30 DTE at the simplest level, but many probably model it against more detailed metrics/scenarios.

    Perhaps the skew in current regime may not make it as cost-effective (in the past I've read it could be done for around zero).

    As you say, there's a stack of papers out there on hedging long S&P portfolios using VIX structures, but not specifically for your case. I'll have a search through my library.
     
    Last edited: Nov 7, 2017
    stevenpaul and jtrader33 like this.
  4. Just to add some color to dunleggin's skew comment, the Jan 15/20 1x2 can be put on for ~.25 right now. That's 68 DTE