Market Hedge

HPI10alpha Program (TaP©)

Over the Hedge: Volatility Hedge

Improve your equity trading performance using proven performance management techniques

revised: 15 May 2019


It seems timely, with the S&P 500 approaching its September 2018 high of 2941, to consider hedging our portfolio. Given the huge, really huuuge, biggest ever tax cut windfall everyone is receiving we need to protect it. The self-aware investor will recognize some of the signs that reducing exposure and lowering the risk profile of their portfolio makes sense whenever the market approaches milestones.

In this case, we are approaching the 3000 level, one that will very like prove hard to punch through with any authority.

At the same time, we are approaching the last resistance level at 2941, the level from which we then took a 20% correction.

Couple that with lack of real compromise on the tariffs, the brewing tiff with the EU, continuing lack of material progress by our political elite on things like infrastructure and 'ho-hum' comes to mind going into May.

Hopefully some bump from tax refund inflows, better earnings than we deserve, but then what?

Certainly, anything can and will happen. We are not calling a top; instead, we think some prudent, low cost insurance might be in order such that we can retain a majority of our gains to date while staying in the game.

The other benefit from having insurance is that the investor may be more comfortable continuing to invest new money or improve the portfolio positions. With insurance, there is a reduced level of fear and less energy spent considering the downside.

We refer often to the cognitive bias named The Disposition Effect as it applies more often than not when things are going well. It is worth the time for another read.


Checking around, people pay about 0.5% of their home's value in annual insurance. While mileage may vary, some get to pay more for their Taj Mahal with the gold bath fixtures and flying carpets; some are blessed with tornado, flood, earthquake or avalanche insurance. But, generally, that is the neighborhood for insurance.

It would be terrific if market insurance were that low but it is good to have some feel for what insurance costs.

Consider that the probability of your house being demolished this year may be pretty low. Unless you live in a mobile home along tornado alley or the Gulf coast. For whatever reason, mobile homes are magnets for destruction. And, likely get the pleasure of paying more in insurance.

In any event, the cost of insurance will be directly related to the amount of potential damage and the probability of occurrence. It is the same for portfolio insurance.

John Huber reviewed the period from 1825 to 2013 and noted the following:

As painful as those corrections are when they happen, an optimist's view might leave us thinking the probability of occurrence isn't that bad. Better than a mobile home in Oklahoma City? Hmm.

It would be useful to take a survey to see who has portfolio insurance, at what level and using what tactics.

Without that data, our sense is that few retail investors pay for insurance; fewer pay for the right insurance; and, those that pay for insurance overpay for it.

In the absence of data we can create conclusions without remorse.

Let's see if we can come up with a better mouse trap while keeping in mind that the second mouse always gets the cheese ...


The basic concept for hedging is to plan to lose money on the hedge. When that happens, our longer term thesis is confirmed and our portfolio will be more profitable, well beyond the cost of the hedge.

Our goal, then, is to spend as little as possible while insuring against a significant loss event. That sounds a lot like insuring your house, right? Better to spend less (higher deductible) but only if the insurance provided truly meets your needs in the event of a catastrophic loss.

There are several ways to hedge. Some possibilities:

We will explore the volatility hedge.

Recognize that a hedge is to cover the period between deciding the market is correcting and closing our positions in the portfolio to protect our capital.

This is followed immediately by closing the hedge for whatever gain we can get.

We cannot afford to insure against all losses over the course of a year while holding all of our positions in the face of a catastrophic market event. The discussion above on the probability of occurrence may work to make us complacent such that we may choose to just 'duck and cover'.

Waiting to close portfolio positions hoping for relief or hoping it doesn't cut too deep is not the path for the self-aware investor. Our primary driver is to improve our probability of success in investing, not hope for the best.

Curtailing losses in a correction by 3-5% by taking action can make a significant difference in recovery performance versus just riding it out.

Equally, with a hedge on, hoping to make up some of the incurred loss by waiting to close the hedge turns that into a trade in the face of poor odds for success. Not a reasonable decision.

Close 'em out; close the hedge. No whining; no hoping; no wishing; no excuses. Tomorrow will be another day (seems obvious, right?). It is much easier to rebuild a portfolio with cash than without cash: as Bart Simpson notes, 'doh'.


The volatility index, VIX, is the first benchmark index introduced by the CBOE to measure the market's expectation of future volatility. Constructed using implied volatility on S&P 500 options, it represents the market's expectation of 30 day future volatility and was introduced in 1993.

Volatility measures the degree of variation in price over time. Higher volatility indicates larger price swings and more risk to the investor.

The VIX trends exactly opposite of the market (counter-cyclical), thus the name 'fear index'. The higher the VIX, the lower the market and therefore the higher the investor relative fear factor.

VIX values greater than 30 are linked to large volatility in the market while the VIX below 20 corresponds to more stable market periods.

Volatility may be measured based on statistical calculations over historical prices, calculating mean, variance and standard deviation. The resulting standard deviation is a measure of volatility or risk. This is called 'realized volatility' or 'historical volatility'.

Or, volatility may be calculated by inferring its value based on option prices. Pricing methods such as the Black-Scholes model include volatility to calculate option prices. As such, volatility may be back-calculated given options prices set by the market. This is called 'implied volatility', it is how the VIX is calculated and generally has more merit in measuring market sentiment.

We encourage self-aware investors to track the VIX directly while using the available instruments for hedging and other purposes. There can be some good short term trade opportunities when the VIX gets out of control. When volatility is cheap, certainly the case now as the VIX approaches 12, it is a good time to buy some insurance as it will be equally cheap.

No calculation is perfect; there are assumptions under each. Yet implied volatility is our preferred approach as being better than the alternatives. And, we prefer VXXB as our Exchange Traded Product (ETP) of choice.


The VXXB is an Exchange Traded Note (ETN) designed to provide access to VIX futures. It is a daily, rolling, long position in the first and second months of VIX futures contracts; it reflects market participants' views of the future direction of the VIX as of the expiration of those VIX futures contracts.

Because the VIX, and therefore the VXXB, is counter-cyclical to the market it has the potential to provide more leverage in a hedge at a lower cost. All the other tactics move directionally with the market.


The number of contracts tends to be high for this hedge so commission costs matter. The choice of broker can make quite a difference both in the commissions paid and the relative cost of the spreads purchased.

Each spread is 2 contracts and you may pay to both open and close each unless the spread expires worthless. So, each spread will cost the equivalent of 4 contract commissions and two ticket commissions.

Sometimes you get what you pay for. Do some research prior to choosing the lowest cost provider as the commission cost, while important, may be outweighed by better fills (lower option cost). You may not get both from the same service.

Here is a look at how that might play out based on published rates and anecdotal negotiated rates:

A further optimization is to take this hedge in a taxable account. Given that we would prefer to lose money on it, doing that in a taxable account means we may be able to take some deduction from taxes.

Volatility Hedge Tactic

As the VXXB moves opposite the market, we will purchase a Bull Call Spread. The concept is to pay as little as possible to deliver the insurance level we want. As such, our approach to this tactic is quite different from using it for a profit-making trade.

Insurance Amount

We need to select an appropriate amount of insurance coverage. There are certainly differences of opinion on how to do this; however, here is our decision-making criteria:

Essentially, as we cross through a 10% loss, we feel the probability of continued decline is high enough to take action. It will likely take a little time to close out positions and we would like that completed before the market reaches a 15% decline.

Given a $500k portfolio, we calculate: $500k * 5% = $25k in required insurance. What will change for each investor is when to pull the trigger, i.e., after a 5%, 10% or 15% market correction; and, how much insurance to carry, e.g., 5%, 10% or more.


Insurance is a cost to be managed where $0 is likely not right. Always being fully insured may be equally 'not right'.

We want to go out about 90 days. Shorter term options force more refreshes to stay insured and the cost escalates rapidly.

We can choose June (65 days) or September (156 days). While not ideal, we will take the June over the September as the cost for 156 days will be more than we would like.

We prefer splitting the insured amount into thirds, establishing positions 60, 90 and 120 days out for each third.

We generally do not manage this hedge: it stays in place until it expires.

As subsequent month options become available we make choices on adding them.

There is some very obvious art, rather than science, to this as we take into account market performance, our view of the next 60-90 days and other factors before extending the hedge.

For this article, we will do a single hedge for the total required insurance amount. This simplifies the details while providing clear insight into the process.


We choose low probability OTM strikes to reduce cost; these will deliver high returns in the event of a catastrophe while otherwise not significantly impacting our Profit/Loss for the portfolio.

We use Delta as a way to identify far out of the money contracts and will go somewhere in the 15-25 Delta range.

We also choose a fairly wide spread to help deliver big in the event of a catastrophe. Generally, $3-$5 spreads work well.

The June 34/38 call spread fits the bill. This would mean buying the June 34 and selling the June 38.

Ack! Math

Spoiler Alert! Skip all the nasty math details and use our handy-dandy spreadsheet HPI Volatility Hedge Calculation Tool.

The output from the tool:

Sniff Test

Given all that, how does it 'feel'? Some thoughts:

Consider that the S&P 500 has an historical gain of 8.9% over the last 5 years and 12.4% over the last 10 years.

Spending 2.7% of our portfolio on protection seems to be high for insurance. Keep in mind, we built in a 10% loss before we took action so 60% of the time our insurance never 'kicks in' and therefore expires worthless.

We can likely optimize this a bit. For example, once we are out of the market there is no need for insurance and no compelling reason to re-enter the market.

Sean Williams summarized the number of days in correction for all corrections over 10% in the last 50 years. The range is 18-929 days. Looking at recent data since the 2007 meltdown, the range is 13-157.

Without much analysis, it seems that once a correction happens protection may not be needed for 2 months or longer while the market consolidates and either recovers or doesn't.

If it doesn't, we will be out; if it does we would be edging back in with appropriate caution, meaning perhaps more in cash than risky assets.

All in, the 2.7% will be the high end given a short correction and immediate strong recovery that makes the self-aware investor want to have insurance on what is invested.

It is possible that we will not require insurance for half the year, dropping our costs to a more reasonable 1.3%.

Each investor needs to decide whether this is high, low or a 'Goldilocks' situation. Keeping an eye on the VIX can help.

Final Comments

You will be tempted to exercise the hedge early. We guarantee it.

As the market heads down, your hedge will start gaining value, sometimes rapidly. Here is the risk profile of the position from TradeStation indicating that the position increases in value from $0 to over $30k over a relatively short move in the VXXB.

Resist the temptation. This is not a trade. Several of the charlatan web investment services will talk of using a 'Tredge', the combination of a trade and a hedge. Ignore them.

Should we consider that there is merit in such a trade, we would create that trade while retaining this hedge.

"... techniques shrouded in mystery clearly have value to the purveyor of investment advice. After all, what witch doctor has ever achieved fame and fortune by simply advising, 'Take two aspirins'?" Warren Buffett