January 30, 2004

Volatility Insurance

Rounding up my posts on the VIX, the good news is that you’ll soon be able to use it to hedge market risk. First though, I should explain what the VIX actually is and what it tells us. The VIX is an indicator that measures the market’s expectations for near term-volatility (within the next 30 days). It does this by looking at options prices on the S&P 500. I won’t try and explain the whole calculation (for you options pricing junkies, you can find it at http://www.cboe.com/micro/vix/vixwhite.pdf ) When markets are placid, options prices are cheaper. When markets aren’t placid, options prices go up (you pay a premium for the right to buy or sell something when the direction of its price is unclear.) You can see from the chart below that as the world gets uncertain, options prices (and the VIX) go up. The main point is that the VIX measures fear. It’s often called “The Fear Gage.” And what you can tell from my chart earlier (and the one above), is that bull markets in fear lead to bear markets in stocks. If that’s all the VIX was useful for, it would be very useful indeed. You’d have a great way to call market tops and bottoms. But in a few months, you’ll be able to do more than that. CBOE has applied for a listing for the VIX to trade on the new CBOE Futures Exchange. You’ll be able to trade the VIX. Unfortunately, it will be on the futures market. So you’ll be trading options on futures (something my friend Sue Rutsen at Fox Investments does very well.) But aside from trading options on futures rather than a straight up option, adding the VIX to your toolbox is a good idea if you have a big bullish bet in the market. A call on the VIX is essentially a bet that volatility will increase and that, if the historical relationship holds, stocks will fall. So, by owning VIX calls…you own a kind of bear-market insurance. There are other ways to do this of course, like through long-dated put options on the indexes. But what’s nice about the VIX is that it’s so directly correlated to the S&P. So a S&P bull can own VIX calls and be reasonably confident that a fall in the S&P will be hedged by a rise in the VIX. I’d recommend using the VIX as a way to make directional bets, i.e. the VIX is going to rise or fall. Right now, it’s a simple bet. The VIX is coming off historic lows. It’s got a lot of up to go. I’d buy calls. None of this makes the market less risky. But what’s interesting about a listing for the VIX is that it puts pretty sophisticated hedging at the fingertips of retail investors like you and me. You can take a few simple positions in a Rydex fund, in the VIX, or in broad market index puts, and at least take out, at a pretty cheap price, an insurance policy on your buy-and-hold positions. Insurance probably isn’t the right word, because no one is going to give you your money back if you lose it being long stocks. But now, you can make money on market declines, and you can do it relatively cheaply. That’s progress.


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