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.

Source: Yahoo Finance

VIX Fun Fact

Eddy Elfenbein tweeted this fun fact:

Take whatever today's $VIX is. Divide it by 3.46. That's the market's view of the 1 stand dev range +/- for the next 30 days. $$

For those keeping track at home, 3.46 = 12^(1/2)

And here are the results... blue is the +/- expected range based on the VIX and the red is how well the S&P 500 performed over the following month (i.e. one month returns, one month forward).

For more detail on how well the VIX predicts equity returns, see past posts:

• VIX as a Predictor of the Equity Returns
• S&P 500 / VIX Matrix

Source: Yahoo Finance

S&P 500 / VIX Matrix

As a follow up to last week's VIX as a Predictor of Equity Returns and Model Building / Data Mining posts, I put together the following two 'VIX Matrix' tables. These tables show the:

• One month forward return of the S&P 500
• One month change in the VIX index

against a number of scenarios involving the one month month change in the VIX and the absolute value of the VIX since its 1990 inception.

• S&P 500: Less than -1.0% = Red, -1.0% to 1.0% = Yellow, Greater than 1.0% = Green
• VIX: Less than -2.5% = Red, -2.5% to 2.5% = Yellow, Greater than 2.5% = Green

Lots of interesting information in these tables that I won't bother summarizing (look at it yourself), except to say that even in these turbulent times (bull market 90's, roller coaster 00's), markets were (on average) very mean reverting.

Note that there are plenty of limitations to these tables, most of which involve the limited data points for a number of the cells.

One-Month Forward S&P 500 Performance

One-Month Forward VIX Change

Update: much more on the above from my friend Bill over at Vix and More blog.

Source: Yahoo Finance

VIX Spiking

Remember WAY back (i.e. two weeks ago) when the VIX was below 20? Yeah... me neither.



Source: Yahoo Finance

VIX Curve Whacked

Bill Luby (of Vix and More blog) details in Barrons what a steep VIX forward curve implies (also detailed previously on EconomPic):

When it comes to the Chicago Board Options Exchange's Volatility Index (ticker: VIX), however, investors have much more difficulty getting their arms around what an elevated VIX means. With the "cash VIX" (the widely quoted index) hovering around 22, many are struggling with how to interpret the meaning of VIX futures that are calling for a VIX of 32 in 2011.

So what does a VIX of 32 foretell?

In terms of a strict definition, a VIX of 32 means that approximately one-third of the time the Standard & Poor's 500 index (SPX) will have a daily change of at least 2%. To put the 2% figure in perspective, during the last 20 years the SPX has experienced a daily change of 2% a little over 7% of the time. Even during tumultuous markets in 2008, when stocks experienced unprecedented volatility for an extended period of time, daily changes of 2% or more occurred less than 29% of the time.

Seen in this light, the VIX futures are predicting that 2011 will bring volatility that is comparable to what was experienced in 2008, a year of financial calamity.

How does this 32 level compare to historical "actual" levels?

Taking the rolling 12-month standard deviation of daily returns of the S&P 500 (annualized) going back to 1950, we see that a realized 12-month volatility level of 32 has only happened on two occasions:

1) 1987-88, which is the period that includes Black Monday (i.e. a 20% market crash in a single day)
2) The recent financial crisis



While I don't think current economic / financial conditions are rosy, the other side of a mean-reverting trade (i.e. when VIX jumps, it eventually moves down), that is priced 50% higher than current levels (i.e. a VIX of 32 vs the ~21 current level), and has only happened on two occasions since 1950 seems awfully intriguing.

Source: Yahoo Finance

VIX Calendar Skew

Source: CBOE

VIX Spikes.... AGAIN

Reuters:

U.S. regulators are taking a closer look at unprecedented volatility in stock markets near the close of trading, hunting for any signs of manipulation.

"It is something we're looking at," said Brendan Intindola, a spokesman for the Financial Industry Regulatory Authority. "We're really taking an extra close look at it in the light of the volatility we've seen in the market in recent weeks."

FINRA typically looks at "market on close" activity, which are orders executed as near to the end of the exchange day as possible.

But its surveillance unit has now ratcheted up its examination of possible efforts by some firms to try to raise the price of a stock for marking near the end of the trading day. "Marking the close" is a form of market manipulation.

If the market was skyrocketing rather than tanking, would they be investigating this?

Speechless

Anything I've Ever Done that Ultimately was Worthwhile... Initially Scared me to Death

VIX (the ticker symbol for the Chicago Board Options Exchange Volatility Index) is:

A popular measure of the implied volatility of S&P 500 index options. Referred to by some as the fear index, it represents one measure of the market's expectation of volatility over the next 30 day period.

VIX has soared to 45 in recent days as fear and uncertainly has reigned supreme. While I am bearish on equities for a variety of reasons (valuation, economic slowdown, credit crisis, etc...), maybe I should reconsider. As the title of this post implies (a quote by Betty Bender), it has been worthwhile to invest when the markets price fear at this level.

Comparing the daily VIX level against the following 12 month returns of the S&P 500 (since 1990), equities have performed exceptionally well with VIX at similar levels.

In fact, looking at all periods when the VIX has ended the day above 40, the S&P 500 has averaged a return greater than 23% over the next 12 months.