Well, hedge fund manager Tim Knight was right. Boehner blinked,
the government's back open, and the S&P 500 (NYSEARCA:IVV) hit
a record high Thursday, rallying on news of the latest increase in
the US government's credit card limit.
When there was still some uncertainty about how the standoff in
D.C. would resolve itself, volatility began to rise a bit. From
Tuesday, October 1st, to Wednesday, October, 9th, the iPath S&P
500 Short Term VIX Futures ETN (NYSEARCA:VXX) climbed more than
15%. At that point, I posted a hedge for VXX longs looking to add
some downside protection (See "
Getting Paid To Limit Your Downside On VXX
"). In this post, I'll show how that hedge reacted to VXX's
The October 9th VXX Hedge
This was the optimal collar*, as of October 9th's close,
designed to limit an investor's losses to 20% over the next several
months, for an investor willing to cap his upside at 20% over the
same time frame:
As you can see at the bottom of the screen capture above, the
net cost of that optimal collar was negative, meaning the investor
would have gotten paid $360 to hedge.
How That Hedge Has Reacted To VXX's Drop
Here is an updated quote on the put leg as of Thursday's
VXX closed at $16.37 on Wednesday, October 9th. A shareholder
who owned 500 shares of it and opened the collar above on October
8th had $8,185 in VXX shares plus an outlay of -$360 on the hedge,
so $7,825 taking into account the hedge.
VXX closed at $13.01, on Thursday, October 17th, down 20.5% from
its price on October 9th. The investor's shares were worth $6,505
as of Thursday's close, his put options were worth $1,150, and if
he wanted to close out the short call leg of his collar, it would
cost him $405. So: ($6,505 + $1,150) - $405 = $7,250. $7,250
represents a 7.3% drop from $7,825.
More Protection Than Promised
So, although VXX had dropped by 20.5% at the time of the
calculations above, and the investor's hedge was designed to limit
him to a loss of no more than 20%, he was actually down only 7.3%
on his combined hedge + underlying position by this point.
Options Give You Options
Being hedged gives an investor breathing room to decide what his
best course of action is. A VXX long hedged with this collar could
exit his position with an 7.3% loss now, he could wait to see what
happens, or if he remains bullish on VXX (despite its egregious
long term chart), he could buy-to-close the call leg of this
collar, to eliminate his upside cap. If he's even more bullish, he
could sell his appreciated puts, and use those proceeds to buy more
VXX. He has those options because he's hedged.
*Optimal collars are the ones that will give you the level of
protection you want at the lowest net cost, while not limiting your
potential upside by more than you specify.
algorithm to scan for optimal collars was developed in conjunction
with a post-doctoral fellow in the financial engineering department
at Princeton University. The screen captures above come from the
Portfolio Armor iOS app.
Follow on Twitter @