A recent CBOE press release shed new light on a topic discussed previously in an Options 101 article. A November 21, 2008 Options 101 article had discussed a tactic I had weighed about a year earlier, in the fall of 2007. I, like many others, had what I thought was a brilliant idea, to add some VIX calls to my portfolio to at least partially hedge the downturn I thought was coming.

After talking with my broker and reviewing the CBOE's own warnings about VIX options, I decided against that tactic. I instead took other actions to guard our funds against losses. Maybe I should have gone ahead with the VIX plan, a CBOE press release recently suggested.

A July 8, 2009 CBOE press release summarizes a recently published University of Massachusetts study. Edward Szado, CFA, Center for International Securities and Derivatives Markets (CISDM) at the university, studied market data from March 2006 to December 2008. His study, "VIX Futures and Options--A Case Study of Portfolio Diversification During the 2008 Financial Crisis" concluded that diversifying with long VIX calls or VIX futures would have ameliorated the portfolio losses many experienced in the period from August through December 2008. The study makes the point that the plan is for "diversification" with VIX futures or options, not "hedging."

If three percent of a portfolio were allocated to long at-the-money one-month (front month) CBOE VIX calls from August through December 2008, the CBOE reported, the total sample portfolio's returns were +20.8 percent rather than the loss of 19.7 percent that would otherwise have been experienced. The difference was even greater when long calls 25 percent out of the money were used. Total returns were then 97.2 percent rather than the 19.7 percent loss that otherwise would have been experienced. The CBOE press release ended by quoting this portion of the report's summary: "investable VIX products could have been used to provide some much-needed diversification during the 2008 financial crisis."

Hmm. Very interesting.

But if one were allocating three percent of the portfolio each month to long VIX calls, what happened in other periods during that study, such as the period from March 2006 to July 2007 when markets were on a relentless drive higher? When collaring strategies are studied, I know, those strategies tend to dampen returns during rallies and ameliorate losses during declines. Would a strategy that involved the VIX also dampen returns during rallies? Why didn't the CBOE's press release make reference to the performance during the rally months?

It couldn't be because the CBOE is the exchange on which VIX options and futures are listed, could it? And it couldn't be that, during those rally months, the three-percent allocation to long VIX calls didn't perform so well?

Nah.

I followed the link to the study itself. Its two-page summary concluded with the statement the CBOE had excerpted. However, the sentence previous to the excerpted one had read, "It is clear from the results of the analysis that, while a passive long volatility exposure may result in negative returns in the long term [my emphasis], it may provide significant protection in downturns."

Hmm. Not just dampen gains but "result in negative returns in the long term"?

The study did conclude that "research results . . . suggest that VIX calls may have higher payouts than SPX puts" under the study's conditions, noting that "VIX calls may provide more 'bang for the buck' than SPX puts in diversifying a typical portfolio." If, in anticipation of a downturn, one decides to diversify to offer some protection, that's useful information.

The study's observations again pinpointed the possibility that such diversification, applied passively, "may return negative excess returns." However, the study's author believed that "a selectively applied long volatility position may provide significant diversification benefits." In other words, investors have to be market timers, picking the times when they really do need to have that diversification in place with a reasonable anticipation that they're going to be right about the timing. It's that "selectively" that can get tricky for people, though, isn't it? For example, I've been concerned about the quality of the gains in recent months and thought markets might be near a topping-out zone about a month ago. If I'd been selectively diversifying a hypothetical long portfolio by allocating three percent to VIX calls or futures this last month, would my results have been worse than if I had instead collared those long positions? The study did not answer that question but some graphed results suggested that I might not have been happy with that particular diversification into VIX calls or futures.

So, my bright idea back in 2007 might have been a good one because I wasn't contemplating a passive, each-month devotion of three percent of my portfolio to long VIX ATM or OTM calls. Instead, I was selectively hunting for a method to protect our portfolio against the losses that I saw coming and thought imminent. And that time, I was right. However, my concerns had led me to take a different tactic. I had ultimately decided on that different tactic, going to cash in October 2007 in all but the trading accounts and one small diversified account.

All the concerns my broker mentioned and the CBOE itself points out about the VIX options in its product page description of the VIX--the fact that the underlying is not the VIX itself but VIX futures, their unusual expiration dates and strange calculation of settlement values--still stand. If I had a portfolio full of equities that I wanted to protect using a passive hedging or diversification technique, I think I'd choose one of the collaring techniques rather than one that showed the varied results typified in that study. Copyright considerations stop me from showing the charts, but they're available through the CBOE's products page on the VIX, where various other studies and white papers concerning the VIX are also available.

The University of Massachusetts study covered the March 2006-December 2008 total returns, but zoomed in only on the August through December 2008 period. Therefore, the CBOE press department can't be blamed for centering their comments on that period. However, that other little tidbit about the possible "negative returns in the long term" might have been a wee bit important to include, too, for anyone deciding whether to attempt a strategy of passively devoting a certain percentage of one's portfolio to VIX calls or futures.

So, my point here is not only to discuss one way VIX options could be used but also to pinpoint the attitude we must have when digesting study results. Who or what entity conducted the study? Why is a particular time frame chosen? Who or what entity is discussing the results of the study? As you read the results, do questions arise that need answering before you put the strategy into operation? If you're considering diversification with VIX options or futures, read my November 21, 2008 Options 101 article, found in the archives, pointing out some difficulties associated with VIX options. Also study the full form of Szado's study, available as a click through from the CBOE's product page on VIX options. Make informed decisions.