Using VIX to Dynamically Hedge Portfolio Risk

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 VIXs 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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