The stock market hit and then furiously bounced off a low on March 9th. Since then it has shot up about 30% nearly uninterrupted. Hope abounds that we may be emerging from one of the worst economic disasters in 20+ years. By many measures the frantic chaos of the last year appears to be subsiding, particularly when looking at the resurgence of corporate earnings, stock prices, and declining value of the CBOE Volatility Index (VIX). Yet it is at times like these when it makes most sense to buy insurance, and it just happens to be cheaper than it has been in a long time.
Housing collapsed, lots of people lost their jobs, banks folded, the investment banking industry as we knew it is dead, and the public Treasury has been used in ways rarely seen in U.S. history. Unless you’ve been locked up in a bomb shelter for the last year you know the story. Then on March 10th something strange happened-the market launched into a furious reversal, sending stocks up about 30%:
During the same period the VIX is down 32% (40% for the last 3 months):
For those of you who track the VIX, you’ll remember that on November 20th 2008 it reached a high of just over 80. Falling to its current level of just under 34 seems like a miracle compared to the psychology of doom that persisted just a few months ago.
Many investors, myself included, use VIX as a hedge on stock positions. When market volatility increases-usually when stocks are falling fast and fear dominates-VIX moves higher. To protect your stock investments a reasonable strategy is to buy long VIX. Stocks gets slammed, VIX goes higher.
Since 2001 the VIX has never made it far above 80, even during the dot-com crash and 9/11 tragedy. So when the index peaked at 80 in November it was probably not a good time to use it as a form of portfolio insurance. However, with the VIX back to within “normal” historical range, and even below the 200-day simple moving average of 44, we should once again be considering using the index as portfolio insurance.
Lock in your gains and protect your portfolio-greedy pigs get slaughtered. Recall the Latin proverb by Vegetius: “Si vis pacem, para bellum.”
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Its too early to call it “the bottom”. However, hedging with vix is a good idea.
@Harry – My sentiments exactly. I’m net short on stocks right now. Getting hammered for it, but holding the line.
VIX is once again priced right to use as portfolio insurance.
When you say “buy the VIX” do you mean futures, options, VXX?
Either of the choices you mentioned would be appropriate. I’ve never traded VXX, but it looks good from a quick glance. I typically trade VIX futures.
A critic of my article brought up the point that VIX measures options volatility and is not a perfect hedge on stock positions. He is technically right, but my point was that VIX is inversely correlated to stocks and can therefore be viewed as a partial hedge. You could, theoretically compute precise correlations and weight your holdings to synthesize a perfect hedge, but that is a lot of work for little advantage.
Since VIX measures options volatility, when VIX is relatively low then options contracts will also be advantageously priced as insurance. The critic’s suggestion, which is appropriate, would be to buy options directly on your portfolio positions.
In any case, despite VIX not being a perfect hedge, today’s trading illustrates how it could have saved a good deal of pain for equity investors!
Rob, perhaps people should be looking for a hedge against inflation, too. I can’t understand why the market’s expectation of inflation in the U.S.(difference between yields on non-indexed and indexed bonds) is still so low.
@Winton Bates – I agree 100%. Everyone should be protecting themselves from inflation at this point, particularly because the cost of doing so is unreasonably low.
I constantly read about the deflation argument, and see some merit to considering short-term deflationary pressures a counter to absurdly loose international monetary policies. But the further governments slip into budget deficits, the higher their financing requirements become, and the more money will be created and thrown into circulation.
Couple this with the Fed’s weakening balance sheet, its composition becoming increasingly tenuous with junk assets taken off of bank balance sheets. Typically, the Fed would use treasuries to soak up excess money supply should inflation heat up. Now they are left with a garbage portfolio of illiquid bonds that cannot be sold anywhere near par to temper rapidly rising prices. In essence, the Fed is nearly impotent.
Thanks for the feedback. Hopefully some of our readers benefit from the advice. Inflation will be the big issue globally over the next few years.