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Saturday, April 7, 2012

The VIX as an Equity Hedge

Back in January I posted a pair of VIX / S&P 500 tables that outlined the performance of the VIX and the S&P 500 given recent changes in the VIX, as well as the current level of the VIX. In response, reader Nazumo asked:

In service of the perpetual quest to find cheap and reliable hedging vehicles, I'd be curious to see a third table: (change in SPX / change in VIX) against VIX.
That table is below, but first I'll try to explain in a simple manner exactly what we're looking at.

The x-axis shows how much the VIX has changed over the last month (as of Thursday, this would read a '0 to 2.5 point drop' as the VIX reads 16.70 vs 18.05 a month back), while the y-axis shows how much the S&P 500 has changed over the last month in percent terms (as of Thursday, the S&P 500 would read '2.5% to 5%' as the S&P 500 was up around 2.6%).

That gets us to the 8.4% average rise in the VIX over the next month based on these two historical factors (note that I am not saying this will happen going forward); certainly a nice hedge if you can get it should equity markets sell-off.

So, is the VIX a good S&P 500 hedge? Based on the above table and the previous tables which incorporate starting levels the VIX may be a good hedge when:
  • Markets are calm
  • The price of volatility, as a form of insurance, is cheap
In other words, the VIX may be a nice equity hedge.... when you don't think you need it. By the time you KNOW you need(ed) it, after markets sell-off or when the VIX index is rising, it is likely too expensive to be of value.