Options Theory: VIX Spikes and Portfolio Protection

Since VIX spikes of the magnitude witnessed this week are rare, I want to talk a bit about the impact they have on the cost of portfolio protection. For new traders otherwise unfamiliar with the VIX a brief review is in order.

The VIX measures implied volatility (or demand) for options on the S&P 500 Index. When it’s high, options are expensive, and when it’s low options are cheap.

For the past two years or so bulls have reigned, and market volatility has been subdued. Over that time frame the VIX was hovering around 10, with the occasional foray into the single digits. That made buying puts very cheap. How cheap, you ask? Well, let’s suppose you were buying one-year, 10% OTM puts on the S&P 500 ETF (SPY) to protect your portfolio. In December 2017 when the VIX was around 9.50, and the SPY was $268, a one-year (Dec 2018) $241 put (10% OTM) cost $6.85.

Let’s put that in context. It cost $685 to protect 100 shares of SPY or $26,800. That’s only 2.6% of the total portfolio value. A Bargain!

What about now? With the VIX at 32, or 3x higher than it was in December you can bet the put will be more pricey. With the SPY at $260, we would buy a January 2019 (one-year) $235 put (10% OTM). The cost is $10.40. See the difference?

Now it costs $1,040 to protect 100 shares of SPY or $26,000. That’s 4% of the total portfolio value. Expensive!

If you’re an inquisitive soul, you may be wondering: If the VIX tripled in value (10 to 32) then why didn’t the price of puts triple in value (from $6.85 to $20.55)? If portfolio protection is about 2.6% of the total portfolio value, then why didn’t it rise to 7.8% of the portfolio value when the VIX skyrocketed to 32?

The answer is interesting.

There isn’t one implied volatility reading. Every single option, every strike and month, has its own implied volatility. The VIX was designed to reflect the implied volatility for 30-day options. Remember, we’re not buying one-month options to protect our portfolio. We’re buying one year. So although the cost of a one-month OTM put has likely tripled (it’s actually gone up far more than that), the price of a one-year put has only gone up about 55%.

That should be a comforting takeaway. If you’re just now looking to buy portfolio protection, you have to pay up, but you’re not getting near as hosed if you buy a one-year put versus a 30-day one.

Yet another takeaway is the trade-off with timing your portfolio protection purchases. If you buy when the market is bullish and the VIX is low, the cost is minimal. But you may not end up needing it. If you wait until the market starts to tumble (like now) but the VIX is high, the cost is rich. But at least you have some confirmation that a downtrend is upon us.

It’s worth noting that if you wait too long (such as after a 10% or 15% drop) before scooping up protection, you may be buying puts at the bottom of the correction when they weren’t needed anymore. As with most decisions in finance, you pick your poison. Personally, I prefer the idea of owning insurance before the flood comes.