Long Volatility Hedging

In 2004 I and my colleague in Proteom Capital, Prof. Haftan Eckholdt, came up with the idea of using a long-volatility overlay to supplement the traditional short equity component of a market neutral strategy. The idea was simply to reduce the size of the equity short and replace it with a long position in VIX futures or options. Since it is negatively correlated with the underlying equity index, volatility (in the form of VIX futures or options) would tend to rise when the market declines, acting as an offset in much the same way as a short equity hedge.

But there are potentially two advantages in maintaining a long volatility hedge, in addition to a short equity position:

(i) the impact of the hedge may be positively asymmetric, in that the performance uplift during a decline in the market could exceed the performance drag during an equivalent market advance

(ii) the response of the volatility hedge will be nonlinear, so that during major market declines, such as occurred in 2008, it would outperform a vanilla short-equity offset.

The theory has been tested in a recent study by Edward Szado of UMass in a paper titled “VIX Futures and Options – A Case Study of Portfolio Diversification During the 2008 Financial Crisis.” (forthcoming in The Journal of Alternative Investments in mid-2009).

Edward concludes:

"[W]hile a passive long volatility exposure may result in negative returns in the long term, it may provide significant protection in downturns. In particular, investable VIX products could

have been used to provide some much needed diversification during the 2008 financial crisis."

Read more here.