How effective are VIX call options as a tail hedge?

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AcadiFi · Accepted Answer

VIX call options profit when VIX rises - which typically coincides with equity crashes (VIX-SPX correlation approximately -0.7). In principle an attractive tail hedge, but practical complications.

**Mechanics of VIX options**:
- Underlying: VIX futures (not spot VIX). VIX options settle to the SOQ of the corresponding VIX future.
- European-style exercise.
- Cash-settled at expiration.
- Contract multiplier = $100.

**Why VIX options are complex**:
- **Spot vs futures**: spot VIX is non-tradeable; futures trade at different levels along the term structure.
- **Term structure**: VIX futures usually in contango (longer maturities higher than spot). A 3-month VIX future might trade at 22 when spot VIX is 16 - meaning even if spot doubles to 32, the 3-month future may only rise to 26.
- **Roll costs**: long VIX futures via ETPs (VXX, UVXY) decay 5-10% per month in normal conditions.
- **Implied vol of implied vol**: VIX option implied vol (the 'vol of vol') is high, around 80-100%. Options expensive.

**Empirical performance**: during March 2020, spot VIX spiked to 82 from 15. 1-month 20-strike VIX calls bought at $1 became worth $40+ at peak. Massive payoff.

But outside of such events: VIX options decay rapidly. A continuous rolling strategy of 2x OTM VIX calls typically loses 30-50% per year in calm markets.

**Comparison to SPX puts**:
- **SPX puts**: pay off in proportion to price decline. More predictable payoff-to-cost ratio.
- **VIX calls**: pay off in vol spike - can be enormous but less predictable.

**Best practice**: combine both in small sleeves. E.g., 0.5% of portfolio to SPX 10% OTM puts, 0.3% to VIX 20-strike calls. Diversifies hedge mechanism.

**Key pitfall**: buying too-far-OTM VIX calls (e.g., 35-strike when spot VIX is 15) - they need extreme spikes to pay off and decay aggressively.

How effective are VIX call options as a tail hedge?

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