International Journal of Financial Management

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Using VIX to Dynamically Hedge Portfolio Risk


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1 Washington Trust Bank
     

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Many investors accept “buy and hold” as their long-term investment strategy. However, during periods of heightened risk, staying disciplined can be problematic. Alternatively, market timing appeals to our emotions but is very difficult to employ successfully. Between these two extremes lies tactical asset allocation, where limited variances are allowed to take advantage of market conditions. Dynamic hedging is a form of tactical asset allocation. Instead of relying on future predictions of asset class returns, dynamic hedging strives to reduce portfolio risk when market risk is elevated. This paper presents a dynamic hedging strategy developed to accomplish this goal. It uses VIX’s normal trading range to assess market risk. When VIX trades above its normal trading range and the upper Bollinger band, the dynamic hedging strategy is applied. The result is that portfolio risk is lowered when market risk is extreme. The application of this strategy provides better returns, lower volatility, and better downside protection than a strategic “buy and hold” allocation. It also avoids the deployment problems associated with market timing strategies.

Keywords

VIX, Dynamic Hedging, Tactical Asset Allocation.
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  • Using VIX to Dynamically Hedge Portfolio Risk

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Authors

Richard Cloutier
Washington Trust Bank

Abstract


Many investors accept “buy and hold” as their long-term investment strategy. However, during periods of heightened risk, staying disciplined can be problematic. Alternatively, market timing appeals to our emotions but is very difficult to employ successfully. Between these two extremes lies tactical asset allocation, where limited variances are allowed to take advantage of market conditions. Dynamic hedging is a form of tactical asset allocation. Instead of relying on future predictions of asset class returns, dynamic hedging strives to reduce portfolio risk when market risk is elevated. This paper presents a dynamic hedging strategy developed to accomplish this goal. It uses VIX’s normal trading range to assess market risk. When VIX trades above its normal trading range and the upper Bollinger band, the dynamic hedging strategy is applied. The result is that portfolio risk is lowered when market risk is extreme. The application of this strategy provides better returns, lower volatility, and better downside protection than a strategic “buy and hold” allocation. It also avoids the deployment problems associated with market timing strategies.

Keywords


VIX, Dynamic Hedging, Tactical Asset Allocation.

References