Is This Why VIX Is Behaving So Strangely?
Hedging basic equity positions with options is nothing new. Buying Puts or selling calls to protect or enhance your position is not uncommon. The relative price that is paid (or received) for that protection is the implied volatility - it is the lever with which supply and demand for protection is turned (and is highly anti-correlated with equity movements). Strategies to hedge large equity positions have become more and more complex (as more and more complex instruments have become available).
One such strategy is to buy VIX calls against a long S&P 500 position - the best being that if the long equity position gets in trouble, VIX will rise and the call will lever that gain to offset MtM losses - i.e. a hedge. But VIX calls can be expensive and so, as we noted from Barclays, a more advanced strategy is to buy risk-reversals (long out-of-the-money VIX calls against short out-of-the-money VIX puts) which creates a 'synthetic long volatility position' to hedge the long equity underlying position. Given the leverage of the options, typically this has been done at 30% of notional to reduce the cost of the hedge.
SPX Hedged with VIX Risk Reversals
VIX call options are expensive due to the high implied realized volatility premium of VIX options. Cost of buying the call options can be reduced by selling OTM put options on VIX. Similar to the call hedge, we buy one-month 20% OTM call options to hedge SPX but also sell one-month 20% OTM put options on VIX to reduce the cost of the calls. The notional of VIX call options bought and put options sold is kept at 30% of the equity portfolio. The premium paid (or received) from buying and selling the options is borrowed (or deposited) at the Fed funds rate. Similarly, the equity position is adjusted according to the gain or loss from the option positions and the interest amount at each rebalance date.
Historically, VIX has not had many spikes to the downside and even though OTM puts are cheaper than OTM calls, they are still a good sell, in our opinion. The risk of being short these puts is mitigated by the convexity of VIX to SPX which ensures that the downside to volatility is capped. In terms of performance, this works the best amongst the VIX options based equity hedges.
This strategy has been very successful in hedging downside in the S&P 500 since the crisis began. The last few weeks has seen the return from the hedged strategy converge to the S&P 500's performance and we suspect this has been the trigger for exits - i.e. given the clarity we have now relative to 2008 on just how FUBAR everything is, let's reduce size as opposed to hedge.
The performance of the SPX + VIX Risk-Reversal strategy has perfectly converged (see below) from the cliff-edge of the financial crisis - we suspect the highly active strategy along with concerns over technicals in short-term vol may be leading many to unwind such synthetic positions.
This unwind of a very popular risk-reversal hedge in VIX options is implicitly like selling volatility - hence the dramatic outperformance of front-month vol even as stocks and credit are not soaring to such highs.
Watching the skew between VIX calls and puts may give us some sign that this exuberant compression is over.