In recent times, and in various places, one hears again and again of an upcoming crash or at least a downtrend on the stock markets. We do not want to go into the various sources, signals and indicators or the intermarket analysis in this article, but put the focus on a hedge instead.
Currently, we have approximately $35,000 worth of stocks in our real money account, all of which are intended to be long-term investments. A hedge of such positions is basically not necessary, as we believe in long-term success and can also take advantage of intermediate price declines. However, considering the entire account, it is important to us that the account not suffer excessive fluctuations.
Why we do not use stock puts as hedge
Of course, you could also simply buy puts on a stock index to protect against falling stock prices, but in such a case there is the following problem:
- You cannot anticipate the timing of the price decline. So it may be that the markets will rise for a while before they fall. In such a scenario, you make relatively little money or even make losses with the purchased put.
It should be mentioned at this point that it makes no sense to permanently hedge against falling prices with puts, as this is at the expense of performance. A purchased put is a kind of insurance, which costs money.
Why do we use VXX as a hedge?
To understand the VXX, let’s take a look at the VIX. The VIX shows the implied volatility of the options on the S&P 500. The correlation is as follows: When the S&P 500 falls, the demand for hedging or the demand for options rises. In such a case, implied volatility increases, driving the VIX higher. The following charts show the interaction very clearly:
It can be clearly seen that the VIX rises sharply when the S&P 500 falls.
Now you cannot act directly on the VIX itself, and there are no options on it either. However, derivatives exist on the VIX, e.g. the VXX, which is an ETN. It indirectly maps the development of the VIX. The disadvantage of the VXX is that it tends to fall, which you can see in the following chart:
The development of the VIX and the VXX is by no means identical, but the parallels with increasing volatilities are clear.
We bought 10 call options on the VXX with the Strike 28 for our real money account. If the stock market falls now and the VXX rises, for example at 40, then we have the right to buy the VXX at 28 and sell it at 40 on the market with profit. This would mean a profit of $12,000. If the VXX stays below 28 in the next 30 days, we will lose the paid premium of $740 (10 pieces), which is 0.6% of our account.
Alternative to VXX Calls
Alternatively, you could have sold a bull put spread. The premium income of the bull put spread could then finance the expenses for the calls. This approach would result in less expense or loss when the VXX is running sideways or falling slightly. The disadvantage, however, is that the losses are larger if the VXX falls stronger. A payoff profile might look like this:
Contrary to the bought calls, one loses money at the end of term only if the VXX lies under 22. However, if the VXX falls below 20, the maximum loss is $1,920 (10 pips), unless you take action in advance.
Once again: We do not do this trade because we want to make money with the calls, but because we want to protect our long positions in the stocks.
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