Tryon is long several equity positions based on event-driven ideas that, over the next few quarters, are expected to have double-digit returns. He is concerned, however, that the equity market may decline as a result of lower corporate earnings. He believes investors are complacent as reflected in the historically low level of the volatility index (VIX). He wants to establish volatility exposure as a tail hedge for his holdings and notices the VIX futures curve is in contango. Tryon evaluates three potential trades to establish his hedge:
- Trade 1: Go long back-end month futures contracts on the VIX Index, with a gross notional equal to the portfolio market value.
- Trade 2: Sell a rolling series of out-of-the-money put options on VIX futures.
- Trade 3: Go long a variance swap, with vega notional equal to the potential equity portfolio loss.
Heding against an increase in volatility would mean you go long - Trade 3. But, honestly, I first read the question as volatility remaining low… so, I first went for hedging against low/decreasing volatility. How do we know it is a higher volatility that is expected? Thank you.