Hedge the Downside with a VIX Vertical Call Spread

Let’s talk today about another way to hedge your stock portfolio against a major move down, albeit indirectly. We can do this by using options on the CBOE Volatility Index (VIX) in the form of a vertical call spread.

The VIX is an index which provides a measurement of implied volatility in the S&P 500 over the next 30 days. Remember that there are two kinds of volatility, historical and implied. Historical is just that, looking backward. Whereas implied volatility is what the market, in its wisdom of supply and demand, thinks the volatility will be.

Higher volatility means higher option prices as large swings are expected. Low volatility means that little is expected in the way of market movement.

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Some people call the VIX the Fear Index, as volatility tends to explode in falling markets and collapse in rising markets. This means that an alternative way to trade an anticipated down move is to buy a VIX vertical call spread.

At this writing (March 4, 1:30 CST), the VIX is trading at 14.35, more than 10% down from yesterday as the Russia/Ukraine situation has, apparently, calmed for the moment and stocks are rallying with the S&P 500 up 1.33%.

The VIX 52-week range is 11.05 – 21.91, which clearly suggests we are on the low end of this range even given the ongoing political uncertainty.

Should stock prices tumble again, the VIX could easily explode higher. So, let’s look at a favorable risk vs. reward strategy.

Let’s look at the May 15-19 call spread. This spread is trading at one. That means that if the VIX is over 19 in May (not at all unlikely, and under the 52-week high) the spread will expire at four. So, you are risking one to make three, which I consider to be a highly favorable risk/reward ratio.

Even as a speculative trade it has good odds. Don’t forget, if you do this “on spec” it’s always a good idea to “take a double”. Meaning that if you buy the spread 10 times at one and it goes to two, you sell the spread five times which gives you the other five for free. We all love to play with the House’s money, right?

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