The Chicago board options exchange's volatility index (symbol: VIX), which measures the level of option premiums on the S&P 500 composite index, traded at a historic low on July 27. That price indicated extreme complacency among market participants.

Extreme readings on the VIX often precede market-moving events, up or down. In this case, it preceded a market sell-off as political tensions between North Korea and the U.S. heated up. VIX surged by some 13.42% on Aug. 10, when the S&P 500 declined by 1.45%.

VIX is the closest thing to the perfect hedge against equities' downturns. VIX has a negative 0.73 correlation with equities and generally is six times more volatile than the S&P 500. A little money in VIX hedges a significant amount of equities exposure.

But hedging with volatility is a complex strategy. The tool of choice for retail investors is Barclays Bank PLC's iPath Exchange Traded Notes (ETNs). There are two main options in this space: iPath S&P 500 Short Term Futures (symbol: VXX), which tracks volatility based on the short-term (i.e., front two months) options on the S&P 500; and iPath S&P 500 Mid-Term Futures (symbol: VXZ), which is priced off third- and fourth-month VIX options on the S&P 500. The underlying instrument for the ETNs are S&P 500 volatility futures.

There are many challenges with volatility futures, notably, the lack of any cost-of-carry metric. Whereas most futures contracts are valued on the cost of carrying the underlying index to delivery, volatility futures are priced on investors' expectation about risk. Volatility is not a commodity to be delivered at some point, so there is no intrinsic cost-of-carry. Volatility futures can, and often do, trade at a significant premium or discount to the cash market, which has an exponential impact on the daily pricing of the ETNs. To that point, the ETNs are rebalanced daily and will decline even when volatility trades within a tight range.

Dual benefits

The daily rebalancing undermines the complexities associated with the theoretical benefits of hedging with volatility ETNs. For most clients, volatility ETNs are simply too complicated. One approach advisors might consider when recommending volatility ETNs is to approach it from the perspective of a covered call strategy. The potential return from a VXX covered call can be significant, although it will limit the hedging benefits of the ETN.

VXX covered calls were used in an options writing pool. On July 21, shares of VXX were bought at US$11.369 and the August 11.50 calls (expiring on Aug. 11) were sold at US44¢. VXX was called away at US$11.50, for a net gain of 5.02% over 15 days. While providing only a limited hedge for the U.S. equity positions, it did provide excellent cash flow , the underlying strategy in an options writing pool.

Another benefit was that the short call provided downside protection against the negative impact from rebalancing VXX during periods in which volatility trades within a tight range. The decline in the short calls negated virtually all the rebalancing impact on VXX prior to Aug 10.

The VXX covered-call strategy provides the dual benefit of generating positive cash flow while providing a limited equities hedge far superior to hedging equities with gold. The VXX covered call can be useful for clients because it's easier to understand. With the short call offsetting much of the downside related to the daily rebalancing, clients are better able to accept the underlying security's ups and downs.

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