DEAL­ING WITH VOLATIL­ITY

Volatil­ity ETNs can be used to help hedge eq­ui­ties

Investment Executive - - CONTENTS - BY RICHARD CROFT

VIX is the clos­est thing to the per­fect hedge against eq­ui­ties’ down­turns, but the strat­egy for do­ing so is quite com­plex.

the chicago board op­tions ex­change’s volatil­ity in­dex (sym­bol:VIX), which mea­sures the level of op­tion pre­mi­ums on the S&P 500 com­pos­ite in­dex, traded at a his­toric low on July 27. That price in­di­cated ex­treme com­pla­cency among mar­ket par­tic­i­pants.

Ex­treme read­ings on the VIX of­ten pre­cede mar­ket-mov­ing events, up or down. In this case, it pre­ceded a mar­ket sell-off as po­lit­i­cal ten­sions be­tween North Korea and the U.S. heated up. VIX surged by some 13.42% on Aug. 10, when the S&P 500 de­clined by 1.45%.

VIX is the clos­est thing to the per­fect hedge against eq­ui­ties’ down­turns. VIX has a neg­a­tive 0.73 cor­re­la­tion with eq­ui­ties and gen­er­ally is six times more volatile than the S&P 500. A lit­tle money in VIX hedges a sig­nif­i­cant amount of eq­ui­ties ex­po­sure.

But hedg­ing with volatil­ity is a com­plex strat­egy. The tool of choice for re­tail in­vestors is Bar­clays Bank PLC’s iPath Ex­change Traded Notes (ETNs). There are two main op­tions in this space: iPath S&P 500 Short Term Fu­tures (sym­bol: VXX), which tracks volatil­ity based on the short-term (i.e., front two months) op­tions on the S&P 500; and iPath S&P 500 Mid-Term Fu­tures (sym­bol: VXZ), which is priced off third- and fourth-month VIX op­tions on the S&P 500. The un­der­ly­ing in­stru­ment for the ETNs are S&P 500 volatil­ity fu­tures.

There are many chal­lenges with volatil­ity fu­tures, no­tably, the lack of any cost-of-carry met­ric. Whereas most fu­tures con­tracts are val­ued on the cost of car­ry­ing the un­der­ly­ing in­dex to de­liv­ery, volatil­ity fu­tures are priced on in­vestors’ ex­pec­ta­tion about risk. Volatil­ity is not a com­mod­ity to be de­liv­ered at some point, so there is no in­trin­sic cost-of-carry. Volatil­ity fu­tures can, and of­ten do, trade at a sig­nif­i­cant pre­mium or dis­count to the cash mar­ket, which has an ex­po­nen­tial im­pact on the daily pric­ing of the ETNs. To that point, the ETNs are re­bal­anced daily and will de­cline even when volatil­ity trades within a tight range.

DUAL BEN­E­FITS

The daily re­bal­anc­ing un­der­mines the com­plex­i­ties as­so­ci­ated with the the­o­ret­i­cal ben­e­fits of hedg­ing with volatil­ity ETNs. For most clients, volatil­ity ETNs are sim­ply too com­pli­cated. One ap­proach ad­vi­sors might con­sider when rec­om­mend­ing volatil- ity ETNs is to ap­proach it from the per­spec­tive of a cov­ered call strat­egy. The po­ten­tial re­turn from a VXX cov­ered call can be sig­nif­i­cant, al­though it will limit the hedg­ing ben­e­fits of the ETN.

VXX cov­ered calls were used in an op­tions writ­ing pool. On July 21, shares of VXX were bought at US$11.369 and the Au­gust 11.50 calls (ex­pir­ing on Aug. 11) were sold at US44¢.VXX was called away at US$11.50, for a net gain of 5.02% over 15 days. While pro­vid­ing only a limited hedge for the U.S. eq­uity po­si­tions, it did pro­vide ex­cel­lent cash flow , the un­der­ly­ing strat­egy in an op­tions writ­ing pool.

An­other ben­e­fit was that the short call pro­vided down­side pro­tec­tion against the neg­a­tive im­pact from re­bal­anc­ing VXX dur­ing pe­ri­ods in which volatil­ity trades within a tight range. The de­cline in the short calls negated vir­tu­ally all the re­bal­anc­ing im­pact on VXX prior to Aug 10.

The VXX cov­ered-call strat­egy pro­vides the dual ben­e­fit of gen­er­at­ing pos­i­tive cash flow while pro­vid­ing a limited eq­ui­ties hedge far su­pe­rior to hedg­ing eq­ui­ties with gold. The VXX cov­ered call can be use­ful for clients be­cause it’s eas­ier to un­der­stand. With the short call off­set­ting much of the down­side re­lated to the daily re­bal­anc­ing, clients are bet­ter able to ac­cept the un­der­ly­ing se­cu­rity’s ups and downs.

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