Why the VIX works as a hedge, and when it doesn't

The VIX mostly works as a portfolio hedge because of the skew.

A simple way to think about the VIX: one-month at-the-money vol on the S&P, plus a spread. Call it 3 points in normal markets, and assume that spread is fairly stable.

When the market goes down, at-the-money vol goes up, because you're riding up the skew. Downside strikes trade on higher vol. As spot falls into them, the at-the-money vol rises, and the VIX goes up with it.

Now flip it. If equity skew were the other way round, with vol going up on the upside, the VIX would rise when the market rose and fall when it fell. You wouldn't have much reason to use it as a hedge.

When the market goes up, the VIX typically goes lower, unless vol has already hit some sort of floor. Then there's a bit more nuance, and you can get the odd day where the market's up and the VIX is up with it.

Which brings me to right now.

The street seems to be in an unusual position: short upside calls and long downside puts. That makes it harder for the VIX to keep its usual negative correlation to the S&P. On a rally, vol can get bid instead of coming in, so the VIX becomes a less effective hedge.

The big JPM quarterly collar roll at quarter-end did take some skew off the market makers' books, though. So the positioning may be getting a bit more balanced.

Knowing what makes a hedge work, and what can quietly stop it working, is embedded in my framework. Where the VIX gets its hedging power. What positioning can do to it. When a different hedge might do the job better.

My framework is revealed (parts of it) in the link below.

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