To The Moon

When the Volatility Index (VIX) exceeds 20%, it is indicating heightened market volatility and potential downside risk, inverse ETFs can serve as a tactical hedge.

In this article, I would like to share the approach I would use to effectively utilize inverse ETFs.

Current VIX Level - Above 27

Currently the $Cboe Volatility Index(VIX)$ is above 27 which signal market is experiencing high volatility and fear, there are panic selling as seen in last night trading, and there is a potential market bottoms.

So VIX > 25, that signals high volatility/fear (panic selling, potential market bottoms).

Select the Appropriate Inverse ETF

Match Exposure: Choose inverse ETFs aligned with your portfolio's risk exposure.

Here is what I would choose the ETFs for different purpose. If we looked at what is happening now during the selloff, I would think SH and SPDN might be appropriate.

Broad Market: $ProShares Short S&P500(SH)$ for S&P 500 exposure. As seen from yesterday trade, SH look to build a nice daily uptrend after crossing the 12-EMA, and it is crossing the 50-day period. RSI is also showing momentum increasing, yet not in the overbought region yet.

Leveraged Options: $Direxion Daily S&P 500 Bear 1x Shares(SPDN)$ for 3x daily inverse leverage. We are seeing similar behavior from SPDN, as RSI showing good momentum yet not overbought. The ETF is trading near the 50-day period. This make it a potential candidate to hedge when we saw VIX cross 20% and above 25%.

Sector-Specific: $Direxion Daily Financial Bear 3x Shares(FAZ)$ for financial sector hedging. This ETF might be suitable for investors who are looking for hedging against the weakness coming from financial sector, it is currently in a potential upside, we are seeing it cross the 26-EMA with RSI making a nice upside movement towards the overbought region.

But do watch the financial sector whether there is any recovery coming from any big banks.

Avoid Overcomplication: Focus on ETFs with high liquidity and low tracking error to minimize slippage.

Determine Hedge Ratio

Beta-Adjusted Sizing: Calculate the hedge ratio based on your portfolio’s beta (sensitivity to the market). For example, if your portfolio has a beta of 1.0 relative to the S&P 500, a 10% allocation to SH could hedge 10% of market risk.

Leverage Caution: Use leveraged ETFs cautiously, as they amplify both gains and losses.

Implement Short-Term Hedging

Daily Monitoring: Inverse ETFs reset daily, making them unsuitable for long-term holds. Monitor and adjust positions daily to avoid volatility decay.

Tactical Duration: Deploy the hedge during peak volatility (e.g., around earnings, geopolitical events) and unwind as the VIX normalizes.

Manage Risks and Costs

Tracking Error: We need to be aware that inverse ETFs may not perfectly mirror the inverse of the index, especially during extreme volatility.

Expense Ratios and Liquidity: Factor in management fees and bid-ask spreads, which can erode returns.

Tax Efficiency: Inverse ETFs may generate short-term capital gains; consider tax implications.

One Good Practice Is To Complement with Other Strategies

• Diversify Hedges: Combine inverse ETFs with put options or VIX futures (e.g., VXX) to spread risk.

• Stop-Loss Orders: Use stop-losses to limit losses if the market rebounds unexpectedly.

Behavioral Considerations

• Avoid Timing Pitfalls: High VIX levels often precede mean reversion. Be prepared to exit the hedge if volatility subsides or the market stabilizes.

If the VIX really cross over to extreme fears, VIX > 40: Extreme fear (rare, often during crises like 2008 or 2020), we might need to study past crises (e.g., 2008, 2020) to gauge how inverse ETFs performed during similar conditions.

This Is How I Would Do The Hedge

Currently, we saw VIX spikes to above 25% amid a market sell-off. I would allocate 15% of portfolio to SDS (2x inverse S&P 500) to hedge against further declines.

If the VIX fall below 20%, I will reduce the hedge by 5% for every 5-point drop in the VIX below 20%.

Summary

I believe that by following the one strategy, I could mitigate downside risk while navigating the complexities of inverse ETFs in volatile markets.

But as investors we need to understand these key takeaways.

• Inverse ETFs are a short-term, tactical tool for hedging during high volatility.

• Success depends on active management, proper sizing, and understanding product mechanics.

• Combine with broader risk management practices for a resilient strategy.

Appreciate if you could share your thoughts in the comment section whether you think the proposed strategy would be a good way to hedge inverse ETF when VIX crosses 20%.

@TigerStars @Daily_Discussion @Tiger_Earnings @TigerWire appreciate if you could feature this article so that fellow tiger would benefit from my investing and trading thoughts.

Disclaimer: The analysis and result presented does not recommend or suggest any investing in the said stock. This is purely for Analysis.