From the Top

And the Biggest Market Disaster of 2012 Is...

The theory of using VIX calls to hedge isn't holding true

by 11/21/2012 11:05 AM
Stocks quoted in this article:

The following is a reprint of the market commentary from the December edition of the Option Advisor, published on November 15. Prices and the chart are as of the close on November 15. For more information or to subscribe to the Option Advisor, click here.

With about 6 weeks of trading remaining this year, what would you characterize as the biggest stock market "fail" of 2012? Facebook's (NASDAQ:FB) May IPO and the subsequent negative price action (culminating in a decline in excess of 50%) that may have further ramped up the already robust level of ill-regard for the stock market held by individual investors? Apple's (NASDAQ:AAPL) 25% decline from its peak closing level in September, which lopped off about $170 billion in market value from perhaps the only stock on the planet in which huge swaths of investors actually had a high level of optimism and belief? Or the fact that the Market Vectors Gold Miners ETF (NYSEARCA:GDX) is down 10% this year (and down 20% over two years) with gold prices gaining 10% and 20%, respectively, over these periods, thus harpooning investors who take bullish gold positions through mutual funds that invest almost exclusively in the gold stocks and not in the metal?

While none of the above is pretty, particularly when viewed from an individual investor's perspective, I'd suggest the biggest stock market disaster of 2012 has been the utter demolition of the growing contingent of big-money investors who use call options on the CBOE Volatility Index (VIX) to hedge the downside risk in their portfolios. And I'd also suggest this demolition has had a non-trivial negative impact on the performance of hedge funds this year, whose generally mediocre results have put a crimp in the returns of such entities as pension funds.

The accompanying chart displays the levels of VIX call and put open interest from January 1, 2011 to date, and it well illustrates the phenomenal growth in VIX call open interest over this period (the VIX open interest peaks generally occur on option expiration day). VIX call open interest peaked at 3.9 million contracts on 8/17/11 (labeled "A" on the chart) during the heart of last summer's market weakness. This call open interest peak was then matched on 2/16/12 ("B"), and was followed by a regular series of higher peaks this year that reached 6 million contracts on 10/15/12 ("C"). And there is still a possibility that VIX call open interest - currently 5.7 million contracts ("D") - will match or perhaps exceed October's all-time high by the time the November VIX options expire next Wednesday. (Click on the chart below to enlarge).

Daily Open Interest for the CBOE Market Volatility Index (VIX) since January 2011
Chart courtesy of Trade-Alert

But the huge dollars flowing into these VIX calls this year is only half the story. The theory behind buying VIX calls to protect a portfolio from a market decline is that market volatility will rise as the market declines, thus driving the VIX higher and causing VIX calls to appreciate on a leveraged basis. But the S&P 500 Index (SPX) has declined by about 7.5% since its October 18 peak, while the VIX has gained a tepid 3 points over this 4-week period. And since VIX call options can be argued to carry a "double premium" (consisting of time value and the higher forward pricing of the VIX futures), the 3-point gain in the VIX over this period has resulted in losses for most VIX call buyers even as the market was declining sharply. And the utter futility this year of buying VIX calls as "protection" is even better illustrated by the fact that the VIX is flat in the wake of the market's 5% post-election decline.

A "hedge" is not in reality a hedge when both legs of the trade lose money. And the fact that many big players have been long the market in recent weeks only because they felt their downside was protected by their VIX call positions has served to exacerbate the market's weakness, as many of these low conviction longs are forced by these circumstances to pare down their stock positions. And while individual investors are not known to be volatility traders, Michael Santoli of Yahoo! Finance in his piece entitled "On Wall Street, Selling Fear is Good Business" observes "Easily the most successful new class of tradable instruments in recent years has been exchange-listed notes tied to the ... VIX." And, I would add, the iPath S&P 500 VIX Short Term Futures ETN (NYSEARCA:VXX) has declined by about 75% so far this year, a loss neither Apple nor Facebook have managed to approach.

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