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October 5, 2012  Fri 10:10 AM CT

VIX: SEE CHART GET CHAIN FIND STRATEGIES
Market timing has always been a hot and controversial topic in trading. And more recently, timing has become a big issue in the worlds of volatility and "tail risk" hedging.

A slew of VIX-related funds and notes have been introduced in recent years, and most of the newest ones are designed to lessen the cost of volatility premiums. Most funds are doing this through dynamic strategies and volatility timing, as in: "If the VIX is above X, we will have Y percent in long VIX futures or options."

At the same time, a report by State Street Global Advisors has found that 71 percent of the institutional investors polled believe that a significant tail-risk event is likely or highly likely in the next 12 months. It added that only 20 percent of those people are highly confident that they are prepared for such an event.

But there are a couple of problems with the issues outlined above, and some of them reflect fundamental flaws in thinking.

The idea that hedging can be timed is widely prevalent, and it is the reason for the VIX's popular misnomer as a "fear index." Granted, institutional traders do rush to buy protection when the market starts to tank, and that is essentially what the VIX measures. But the fact that the VIX tends to reach a peak at the bottom of most market moves shows that it is a dubious leading indicator.

In fact, hedging can actually be the reason for market disasters, whether they be "flash crashes" or more conventional meltdowns, such as the crash of 1987. The latter was in many ways caused by hedging as "portfolio insurance" providers ran in and increasingly sold futures into the market drop.

The upshot: Timing your hedging strategies can be dangerous, if not disastrous.

There are, however, tangible ways to approach this difficult problem. To that end, I am introducing a "Hedge Zone" system that will be used in future writings to signal circumstances when protection may be needed. Without giving away the nitty-gritty details, I will say that this strategy is based on years of trading experience and relies on metrics from the equity market and the volatility data.

The system uses a simple "stoplight" metaphor, with red, yellow, and green signals. How you use the system will depend on what kind of trader or investor you are. For example:

  • Red means that full hedges should be implemented and/or that you should be long volatility. It could also mean that you should reduce your overall equity exposure.
  • Yellow means that hedges should be in place and short-volatility positions should be reduced or eliminated.
  • Green means that long equity and short volatility are appropriate and that minimum hedges can be used.

This last zone is the trickiest. Crashes have almost always occurred when the market was already in a red or yellow mode--but that doesn't mean they will do the same in the future.

The market is a wild place, and the true "black swan" is the thing that people least expect. So money that presumably "can't be lost" should always be hedged or not invested at all.

I believe that these "hedge zones" will be useful to most of you, if only to get a sense of the general health of the market. By the way, it so happens that we are moving into a green zone today, as long as the market stays positive.

(A version of this article appeared in optionMONSTER's Education Newsletter of Sept. 3.)
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