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A Study in Portfolio Diversification Using VIX Options

Last Updated on 10 February, 2024 by Rejaul Karim

In the pioneering study titled “A Study in Portfolio Diversification Using VIX Options” authored by Dominick Paoloni of IPS Strategic Capital, the inexorable quest for a reliable and cost-effective portfolio tail protection from cataclysmic shocks unfurls with palpable urgency.

This seminal inquiry assumes a pivotal stance to evaluate the efficacy of a systematic VIX call buying strategy as a shield against systemic risk, juxtaposing it against other hedging strategies. The strategic fulcrum of the study revolves around the judicious management of costs, a sine qua non for portfolio managers grappling with the specter of potential market upheavals.

Piercing through the veil of empirical data, the study illuminates the potency of a passive allocation to VIX calls, painting a compelling tableau of efficacy during significant drawdown periods, while expending a defined percentage of capital when the protective shield lies dormant.

With a steadfast adherence to fixed rules, the study endeavors to optimize the moneyness and expiry of VIX call options, heral-ding a clarion call for astute portfolio diversification entwined with the vigilant gaze of risk mitigation.

Abstract Of Paper

The search for dependable, low-cost portfolio tail protection or hedge from exogenous events such as the 1987 crash, the 2000 dot-com bubble, the 2008 credit crisis, and the 2011 European crisis continues. This study assesses the performance of a systematic VIX call buying strategy with a defined cost to hedge an equity portfolio from systemic risk. A portfolio manager must weigh these costs against those of hedging strategies that have potentially undefinable costs, for example, protective puts or shorting equity index futures. The analysis shows that a passive allocation to VIX calls has proven effective in large drawdown periods and can be accomplished by spending a relatively small defined percentage of capital when the hedge is not needed. The study applies a set of fixed rules to empirical data with the goal of optimizing ex-post the moneyness and expiry of VIX call options over the period studied. For the period of analysis, the systematic purchase of properly placed VIX calls tends to provide sufficient protection in tail risk events for minimal cost when hedging is not needed.

Original paper – Download PDF

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Author

Dominick Paoloni
IPS Strategic Capital

Conclusion

In simple terms, “A Study in Portfolio Diversification Using VIX Options” stands out as a crucial piece, highlighting the strength of a VIX call buying strategy to protect against big financial risks.

Dominick Paoloni’s important work gives portfolio managers a solid approach to navigate through the unpredictable ups and downs of the financial world. His effective strategy involves investing in VIX calls during extended periods of financial decline, providing a smart way to safeguard investments.

Paoloni’s approach involves careful consideration of factors like the type and expiration date of VIX call options, making it a standout method for diversifying portfolios. This strategy essentially becomes a top choice for cost-effective protection against unexpected events that could negatively impact investments.

The call for investors to be quick and smart in protecting their money from significant risks resonates strongly, blending innovative thinking with well-established principles of managing portfolios wisely.

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FAQ

1. What is the main focus of the research paper “A Study in Portfolio Diversification Using VIX Options,” and how does it address the need for reliable and cost-effective portfolio tail protection from catastrophic market events?

The main focus of the research paper is to evaluate the effectiveness of a systematic VIX call buying strategy as a means of providing reliable and cost-effective portfolio tail protection from significant market shocks. The study addresses the ongoing quest for a dependable and low-cost hedge against exogenous events such as major market crashes or crises. It aims to assess the performance of a VIX call buying strategy in comparison to other hedging strategies, considering the critical aspect of managing costs, which is essential for portfolio managers facing the potential impact of market upheavals.

2. What key findings does the paper present regarding the performance of a systematic VIX call buying strategy in protecting an equity portfolio from systemic risk?

The paper presents findings that suggest a passive allocation to VIX calls has proven to be effective, particularly during large drawdown periods associated with significant market events. The study indicates that a well-managed VIX call buying strategy can provide substantial protection in tail risk events at a relatively small defined percentage of capital when the hedge is not actively needed. The analysis emphasizes the importance of a systematic approach and fixed rules in optimizing the moneyness and expiry of VIX call options.

3. How does the research paper contribute to the understanding of portfolio diversification, risk mitigation, and the optimization of VIX call options for tail protection?

The research paper makes a significant contribution by highlighting the efficacy of a VIX call buying strategy for portfolio diversification and risk mitigation, especially during periods of substantial market downturns. It provides insights into the optimization of VIX call options, considering factors like moneyness and expiry, offering a systematic and cost-effective approach for portfolio managers. The study’s emphasis on the application of fixed rules adds a layer of discipline to the strategy, making it a valuable resource for investors seeking ways to protect their portfolios from systemic risk.

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