VIX Hedging September 30, 2015 Pravit Chintawongvanich, Head of Risk Strategy

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1 P R O V E N E X P E R T I S E. U N B I A S E D A D V I C E. F L E X I B L E S O L U T I O N S. VIX Hedging September 3, 215 Pravit Chintawongvanich, Head of Risk Strategy

2 Hedging objectives What is the best hedge? Are we protecting against the next 28 or a garden variety selloff? How consistent are we? Discretionary vs. systematic hedging How much are we willing to lose on hedging? Are we protecting a given level of S&P or a drawdown from the highs? Am I trying to hedge against volatility or hedge against permanent losses? Are we trying to make money from hedging or reduce losses? Are we trying to time a downturn? The answer to all of these questions will determine how/if we hedge. 2

3 VIX vs. S&P Market rallying: S&P puts can quickly become irrelevant Losing money on delta VIX calls will also roll down, but in some sense stay more relevant 1,68 1,66 1,64 1,62 1,6 SPX vs. SPX Jul 15 Puts, Apr - Jun VIX is always in play 1, ,56 1 Example: April June 213 Market rallied SPY July puts became irrelevant due to the market rally VIX July calls remained a useful hedge VIX calls are always in play but more expensive to reflect this jump risk 1,54 SPX 5 1,52 SPX Jul 15 Puts 4/1 4/8 4/15 4/22 4/29 5/6 5/13 5/2 5/27 6/3 6/1 6/17 6/24 7/1 1,68 1,66 1,64 1,62 1,6 1,58 1,56 1,54 SPX SPX vs. VIX Jul 17 calls, Apr - Jun 213 VIX Jul'13 17 Calls 1,52 1 4/1 4/8 4/15 4/22 4/29 5/6 5/13 5/2 5/27 6/3 6/1 6/17 6/24 7/

4 VIX vs. S&P S&P puts can be more reactive than VIX calls in an equity selloff S&P puts trade at a much lower vol than VIX calls Near-dated, far out-of-the-money S&P puts (tail puts) can be extremely reactive VIX Aug '11 Calls performance from 7/22/11 Performance to 8/8/211 Performance to 8/16/211 Example: August 211 S&P puts were more reactive in the initial selloff However, they decayed rapidly when the market stabilized Teeny puts may not be useful in a lesser selloff SPX Aug '11 Puts performance from 7/22/11 Performance to 8/8/211 Performance to 8/16/211 4

5 VIX vs. S&P VIX can sometimes be more reactive than S&P (e.g. credit selloff) Example: Dec 214 (11/26/14 12/16/14) Dec VIX futures went from 14.2 to 23.1 HYG declined by 5% SPX declined by 4.8% Generally rare for VIX to react without SPX reacting 14 VIX Dec '14 Calls performance from 11/26/14 SPX Dec'14 Puts performance from 11/26/ Performance to 12/16/ Performance to 12/16/

6 VIX calls vs. S&P puts VIX Calls Advantages VIX is always in play Can sometimes be more reactive than S&P Disadvantages Higher vol premium Higher decay/roll cost Can decay away from strike Less reactive in a severe equity selloff S&P Puts Advantages Lower vol Higher reactivity in an equity selloff Direct hedge to long equity book Disadvantages Can rally away from strike Sometimes less reactive than VIX 6

7 VIX calls vs. VIX futures VIX futures already have option-like P&L profile Buying VIX calls is like buying calls on calls : long vol-of-vol VIX call underlying is VIX futures, not spot VIX VIX calls: sliding away from strike as underlying VIX future rolls down VIX calls may be easier to size & manage (pre-defined cost) VIX calls tend to be bad hedges when VoV is already high 2 strike calls are near the money back in March... July VIX Futures vs. VIX Spot...but no longer as relevant once we get the vol spike VIX July 2 Calls vs. VIX July Futures (Same Initial Delta). Jan-15 Feb-15 Mar-15 Apr-15 May-15 Jun July VIX futures VIX Spot 1 3/1 3/15 3/29 4/12 4/26 5/1 5/24 6/7 6/21 7/5 7/ Calls Futures 7

8 Outright VIX calls: Strike selection OTM VIX calls will outperform on a large vol spike The faster and bigger the vol spike, the more the OTM VIX calls outperform However, you need to nail the unwind exactly right Near-the-money VIX calls have a better chance of retaining their value on a vol spike This only applies if we hold our VIX calls all the way to expiry Will we be able to hold a VIX call that goes in the money? 1, VIX Sep'11 4 Call VIX Sep'11 25 Call VIX Sep 25 vs 4 calls in /1/11 7/15/11 7/29/11 8/12/11 8/26/11 9/9/ VIX Sep'15 3 Calls VIX Sep'15 17 Calls VIX Sep 17 vs 3 calls in /1/15 7/8/15 7/15/15 7/22/15 7/29/15 8/5/15 8/12/15 8/19/15 8/26/15 9/2/15 9/9 8

9 VIX calls: Maturity selection Should we buy near-dated or long-dated VIX calls? Long-dated VIX calls: need to pay option time premium and curve premium Long-dated options less reactive If we think vol spikes sometime but don t know when or by how much, we have no idea of the potential losses and can t calculate risk/reward For hedgers, almost always makes more sense to roll near-dated options Very low and flat VIX curve could make long-dated VIX calls interesting 19. VIX Futures Curve 7. VIX Dec 2 Calls VIX Sep vs. Dec Calls in VIX Sep 17 Calls Spot Aug-15 Sep-15 Oct-15 Nov-15 Dec-15 Jan-16 Feb-16 Mar-16. 7/1/15 7/8/15 7/15/15 7/22/15 7/29/15 8/5/15 8/12/15 8/19/15 8/26/15 9/2/15 9/9/15 9

10 VIX calls: Maturity selection Should we buy a long-dated option or roll several short-dated options? Sizing: Do we budget rolling costs? Are we trying to optimize cost or hedge effectiveness? Fixed monthly budget: known cost, but limits how much hedge we can buy (esp. after vol spike) Fixed position: unknown cost, but known vol exposure VIX Dec 25 calls vs. rolling front month VIX calls in 211 (Fixed Monthly Budget) VIX Dec 25 Calls Front month VIX calls VIX Dec 25 calls vs. rolling front month VIX calls in 211 (Fixed Position) VIX Dec 25 Calls Front month VIX calls /2/11 7/2/11 8/2/11 9/2/11 1/2/11 11/2/11 12/2/ /2/11 7/2/11 8/2/11 9/2/11 1/2/11 11/2/11 12/2/

11 VIX calls: Monetizing Should we try to monetize our VIX calls? VIX vol of vol spikes after the initial move (making VIX calls good sales and expensive buys) VIX calls can decay very quickly after the initial move Extremely difficult to time the top Are we OK with limiting further gains? Is it worth paying the premium to roll to further OTM VIX calls? Example: VIX Sep 17 calls over the past few weeks P&L of VIX Sep 17 calls 12. Monetize Aug 24th 1. Roll to Sep 3 calls on the 24th 8. Roll to Sep 25 calls on the 21st Don't do anything /31/15 8/7/15 8/14/15 8/21/15 8/28/15 9/4/15 9/11/

12 VIX calls: Monetizing Turn VIX calls into call spreads Maintain exposure to higher VIX Take in premium and sell high volof-vol Timing still matters, but is more forgiving than taking off the hedge entirely Example: Selling Sep 25 and Sep 3 calls against Sep 17 calls over the past few weeks P&L of VIX Sep 17 calls 12. Monetize Aug 24th 1. Sell Sep 3 calls on Aug 24th 8. Sell Sep 25 calls on the 21st Don't do anything /31/15 8/7/15 8/14/15 8/21/15 8/28/15 9/4/15 9/11/15 Takeaway It s difficult to time the top -2. Rolling into higher strike VIX calls is extremely expensive (only makes sense if we expect a serious increase in volatility, e.g. 28 scale) Selling VIX calls helps us keep exposure to higher VIX and sells high vol-of-vol 12

13 VIX Call Spreads VIX call spreads are rarely worth their full value before expiry Selling the top strike lowers the initial cost but reduces the convexity Can be useful if you specifically expect a jump in VIX right before expiry Useful if you have a fixed dollar amount to protect Bid to vol-of-vol may result in disappointing marks when we reach the top strike (since we are short it) Sep VIX 17/21 call spread (as of Aug 5 th ) Mark as of 8/5/15 Mark as of 8/19/15 Mark as of 9/2/15 Intrinsic 13

14 VIX Call Spreads: Historical example In Oct 14 the VIX Oct futures closed at 24 for one day, before collapsing The VIX Oct 17/24 call spread was only worth $4.5 mid (out of a total $7) with only a week to expiry We should never expect call spreads to be worth full value unless 1) We way overshoot the top strike 2) We expect to be at or above top strike right before expiry (and are OK w/ waiting for this) VIX Oct'14 17/24 call spread vs. Oct '14 Futures VIX Oct Futures (Left) VIX Oct 17/24 call spread (Right) /11/14 9/18/14 9/25/14 1/2/14 1/9/14 1/16/

15 VIX Call Spreads vs. VIX calls VIX calls are more expensive per contract, but you need less For an instantaneous move, the same dollar premium of calls will be much more reactive VIX Sep 19 calls vs. VIX Sep 17/21 call spread (same dollar premium), instant P&L as of Aug 5 th 1,2, 1,1, 1,, 9, 8, 7, 6, 5, 4, 3, 2, 1, 13-1, VIX Call P&L as of 8/5/15 VIX Call Spread P&L as of 8/5/15 15

16 VIX Call Spreads vs. VIX calls We need to hold VIX call spreads all the way to expiry to realize their full value Impractical hedge if our objective is immediate gains on a move lower Good if we don t care about monetizing or rolling before expiry Good for targeting a specific event right before VIX expiry 1,2, 1,1, 1,, 9, 8, 7, 6, 5, 4, 3, 2, 1, 13-1, VIX Call P&L as of 9/16/15 VIX Call Spread P&L as of 9/16/15 16

17 VIX Call Spreads: Strike Selection Tighter call spreads have better decay, but limit our upside Wider call spreads have heavier decay, but give us more upside 1,, 9, 8, 7, 6, 5, 4, 3, 2, 1, , -2, VIX Sep17-21 P&L as of 9/1/15 VIX Sep17-27 P&L as of 9/1/15 17

18 VIX Call Spreads: Historical Examples In both examples we compare equal dollar premium of calls to call spreads. The calls are more expensive initially, meaning we have fewer contracts of the calls. Sep 215: The calls outperform the call spread on the initial leg down and retain exposure to further increases in volatility. As time goes on, they decay more quickly. Aug 211: The calls massively outperform the call spread, whose P&L is capped. 7 6 VIX Sep 19 calls vs. 17/21 call spread in 215 VIX Sep 19 Calls VIX Sep 17/21 Call Spread 1,6 1,4 VIX Calls vs. Call Spreads in Aug 211 VIX Aug' call VIX Aug'11 2/25 call spread 5 1,2 4 1, Jun-15 Jun-15 Jun-15 Jul-15 Jul-15 Aug-15 Aug-15 Sep-15 7/1/11 7/8/11 7/15/11 7/22/11 7/29/11 8/5/11 8/12/11 18

19 VIX calls vs. VIX Call Spreads VIX Calls Advantages More reactive on initial move Unlimited upside Disadvantages Faster decay May be initially more reactive, but if we monetize it, we cap the gains anyway VIX Call Spreads Advantages Slower decay Disadvantages Less reactive on initial move Limited upside 19

20 Other structures VIX 1x2 call spreads Sell 1x near strike call, buy 2x higher strike call Decay can be fairly minimal if nothing happens (stay near bottom strike) need to roll before expiry Decay becomes very high if we get to the upper strike Long vol-of-vol (which tends to expand during a selloff / vol spike) Needs to be quickly monetized on a vol spike difficult to time the top Mark as of 9/14/15 Mark as of 1/5/15 Mark as of 1/26/15 2

21 Other structures 2.5 VIX 1x2 call spreads historical examples Comparing the 1x2 call spread to a far OTM call sized to have equal decay There has been a buyer of the 3-month 15/21 1x2 call spread ~7 days to expiry (e.g. buy Oct structure before August expiry) Oct 15/21 worked well during the recent volatility, but decayed quickly needed to monetize fast VIX calls retained their value better over time Last year, Oct 214: window for monetizing the 1x2 was very short, underperformed the VIX calls Oct 3 calls vs. Oct 15/21 1x2 call spread in VIX Nov 15/21 vs. VIX Nov 3 calls in Oct '14 2. Oct 15/21 1x2 Oct 3 Calls 1..8 VIX Nov 15/21 1x2 VIX Nov /8/14 9/15/14 9/22/14 9/29/14 1/6/14 1/13/14 1/2/ /1/15 8/17/15 8/24/15 8/31/15 9/7/15 9/14/

22 Other structures VIX Calendar Call Spread Buy 1x near dated call, Sell 1x longer dated call Similar to owning an option on the curve steepness / flatness Can be initial credit or even money, but will decay Curve flattening goes hand-in-hand with vol increasing Should be unwound before expiry to avoid the worst case scenario decay (long worthless front month option and short ATM back month option) Should be quickly monetized to avoid decay 3. VIX Sep/Oct 2 Call Spread Mark /1/15 5/15/15 5/29/15 6/12/15 6/26/15 7/1/15 7/24/15 8/7/15 8/21/15 9/4/

23 Summary There s no best hedge for everyone VIX calls can be a more persistent hedge than S&P puts when the market is rallying Far out-of-the-money VIX calls can be more reactive, but can vanish more quickly Near-dated VIX calls are more reactive than long-dated VIX calls Rolling near-dated VIX calls is usually a better hedge than long-dated VIX calls Rolling into higher strike VIX calls after vol spikes is very expensive Selling VIX calls can help us monetize VIX calls while keeping long vol exposure VIX calls may be optically more expensive than call spreads, but are more reactive on a dollar-for-dollar basis 23

Article from: Risk Management. March 2015 Issue 32

Article from: Risk Management. March 2015 Issue 32 Article from: Risk Management March 2015 Issue 32 VIX & Tails: Hedging With Volatility By Rocky Fishman 9 8 7 6 5 4 3 1 REGIME: SINGLE-DIGIT RV RARE Apr-04 Jan-05 Sep-05 Jun-06 Mar-07 Dec-07 Sep-08 Jun-09