Hedging Short SP Straddle with VIX Options: Strategies and Considerations

The SPX 500 straddle is a popular trading strategy used primarily for volatility. The VIX, known as the ldquo;fear index,rdquo; is a measure of expected market volatility based on SP 500 index options. VIX options, on the other hand, provide another layer of risk management by offering positions on the implied volatility of the VIX itself.

Understanding the Volatility Relationship

The SPX 500 straddle involves taking a position on the volatility of the SP 500 index. The VIX measures the implied 30-day volatility of the SPX 500, and VIX options position traders on future expectations of VIX volatility. Therefore, holding VIX options positions indirectly positions you on the volatility and volatility of volatility (VoV) of the SPX 500.

When considering hedging the original SPX 500 position, you are mainly targeting the vol of SPX 500. However, it is essential to ensure that there is solid reasoning behind the hedging strategy. The SPX and VIX are not perfectly inversely correlated. On average, the VIX increases by approximately 16.8% on days when the SP 500 index drops by 3% or more. This correlation means that while VIX options can help hedge, the dynamics might not always align as expected.

Hedging Strategies

A common approach to hedging a short SPX 500 straddle is to use VIX options or directly hedge using options on the SP 500. One strategy is to use out-of-the-money (OTM) puts and calls in the SP 500 to mitigate the risk. This method mimics the Third Friday Total Return Fund, which leverages this strategy.

OTM Puts and Calls Strategy: OTM Puts: You can buy OTM puts for the SP 500 to protect against a decline in the index. OTM Calls: Conversely, you can buy OTM calls to protect against an unexpected rise in the index.

This strategy aims to offset potential losses in the SPX 500 straddle by providing additional downside protection. The fund mentioned realizes positive returns by selling premiums and collecting time value.

Deciding on a Hedging Strategy

Your decision to hedge a short SPX 500 straddle with VIX options or directly with SP 500 options depends on several factors:

Market Expectations: If you believe the SPX will stay relatively stable, a short straddle might be sufficient. However, if you anticipate high volatility, additional hedging might be necessary. Relative Mispricing: Consider whether SP 500 options or VIX options are overpriced or underpriced. If you believe one market is incorrectly priced, you can exploit the mispricing. Volatility Correlation: Understanding the historical correlation between the SPX and VIX can inform your hedging decision. If the correlation is weaker, you might need more sophisticated strategies. Positioning Goals: You may want to remove specific risk aspects of the trade or align the risks across different markets.

In summary, although the SPX and VIX are not perfectly inversely correlated, using VIX options or OTM puts/calls in the SP 500 can provide valuable hedging against potential volatility. The effectiveness of the hedging strategy depends on a combination of market expectations, relative mispricing, and historical correlations. By carefully considering these factors, you can make informed decisions to protect your positions effectively.