How To Use VIX Options For Portfolio Protection
With the Stock market in a correctionit can be an excellent time to start thinking about portfolio protection.
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Despite Wednesday’s robust recovery, we would like to see more stocks rally back above key technical levels before resuming full uptrend.
That being said, traders with a large bullish exposure should consider adding some protection.
One way to do this is through an options trade known as a ladder.
Using VIX to hedge the portfolio
Let’s consider an example using options on the Cboe Market Volatility Index, commonly known as the VIX.
To set up a call ladder, we sell an at-the-money call option. Then buy an out-of-the-money call and another out-of-the-money call.
We receive credit from selling the at-the-money call and pay debits for the two out-of-the-money call purchases.
The goal is to place trades in the VIX index options at zero tariff or, in the worst case, at a small debit.
Using the November schedule, this might look something like this:
Sell on 1-Nov-16, 30 Call at $3.90
Buy 1 call of 16-Nov-35 at $2.80
Buy 1 call of 16 Nov 50 at $1.25
We receive $390 for selling the 30 strike call and pay $405 for buying the 35 and 50 strike calls.
Trade offers protection against spikes in volatility
Therefore, the trade meets the criteria to be placed for a small debit of $15.
This trade provides some protection in the event of a large spike in volatility in the coming weeks.
Normally I would hold this hedge trade for about two weeks and then close it out when no longer needed.
VIX options behave slightly differently than stock options, so make sure you understand how they work before risking any capital.
Please remember that options are risky and investors can lose 100% of their investment.
This article is for educational purposes only and is not a trading recommendation. Remember to always do your own due diligence and consult your financial adviser before making any investment decisions.
Gavin McMaster holds a Masters in Applied Finance and Investment. Specializing in income options trading, he is very conservative in his style and believes that patience while waiting for the best setups is the key to successful trading. Follow him on Twitter at @OptiontradinIQ
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