Using Volatility-Target Index Options as Portfolio Hedges
Summary
The document explains why portfolio managers might buy calls or take long exposure to options on a volatility-target index. Such exposure can provide gains in turbulent markets, which may help offset losses in portfolios with a long equity bias when volatility and negative returns coincide. The index may offer a hedge that more closely matches the risk the manager wants to address, and could require less frequent adjustment than a VIX position.
The answer compares these contracts with variance swaps, VIX options, and index futures puts, noting that those alternatives may offer more liquid or transparent ways to obtain protection. It also observes that packaged bank products can be easier for managers to present to investors. The discussion is qualitative and offers no data, pricing analysis, or evidence that the claimed return relationship holds consistently. It cautions that the packaged options may be costly and that the best hedge depends on liquidity, monitoring needs, and the portfolio’s risks.
Key ideas
- Long exposure to a volatility-linked index may gain during turbulent markets and cushion losses in long-biased portfolios.
- A volatility-target index option may align more directly with a manager’s intended hedge than a broad volatility product.
- Variance swaps, VIX options, and index futures puts are alternative ways to seek protection.
- The answer argues that packaged options may be expensive and does not quantify their hedging benefit.
Tags
Full text
# Why write options on a volatility target index? # Why write options on a volatility target index? There seems to be increasing interest in risk controlled products such as volatility target indices and derivatives products on these underlyings. From a risk management perspective what are the advantages of these products? ## Answer by Brian B (score 4) https://quant.stackexchange.com/a/1691 Typically these options are sold to portfolio managers to help smooth out their returns in times of trouble. A call (or even long position) on such an index will give a little PL in precisely the sort of markets that long-biased portfolio managers often lose money in, since high volatility is empirically correlated with negative returns. That keeps risk down, and PL smooth. Most of these customers could be trading variance swaps or options on VIX instead. They could even use stock futures index puts to get insurance they want. These options are "more precisely targeted" at what they think they want to hedge, and require less frequent attention than VIX positions (though not necessarily less than a varswap). In addition, a hedge fund manager who says to his investors that he hedges risk with varswaps or VIX invites questions about his competence with those products, whereas one who buys protection marketed by an investment bank is presumed -- by the typical HF investor -- to have received proper guidance from his bankers on the investment. In practice, I am sure that the options are terribly expensive trades for the customers, many of whom would be better off with trades in more liquid and transparent securities such as varswaps or (if they can spare the time) stock futures option/VIX positions. It's cheaper, and I attribute scant value to the advice of the bankers.
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