Using Volatility Futures as Extreme Downside Hedges

Abstract

“Long volatility” is thought to be an effective hedge against a long equity portfolio, especially during periods of extreme market movements. This study examines using volatility futures and variance futures as extreme downside hedges, and compares their effectiveness against traditional “long volatility” hedging instruments such as rolling series of 5% and 10% out-of-the-money put options. Using contract-rolling methodologies that are generally consistent with market practice, our results show that VIX volatility futures seem to be a more effective extreme downside hedge than traditional option rolling strategies with 5% and 10% out-of-the-money put options on the S&P 500 index as well as variance futures. In particular, using 1-month rolling VIX futures and a reasonable hedging model presents a cost-effective choice as a hedging instrument for extreme downside risk protection as well as for upside preservation. This observation is significant, since there are not yet obvious theoretical justifications as to why using VIX futures can be more efficient than using the underlying options when dealers are likely to charge defensive margins due to imperfect replication.