The Protection Connection

by Jay Pestrichelli on December 6th, 2011

While yesterday’s move wasn’t one of the most exciting days the market has had this fall, it was very interesting to those of us that hedge; particularly those that use puts as a means of protection.

The S&P 500 (SPX) was up about 1% to 1257, but the VIX, which typically has a negative correlation, was also up 1%. This is a reverse of the usual move. In fact when the SPX is up 1% we expect the VIX to be down 2-3%.

We’ve all heard that the VIX is a measure of uncertainty or that it carries the label of the fear indicator (the higher it is the more fear there is in the market), but actually it is a measurement of the implied volatility of the SPX.

But few realize, it represents the price of buying options, and in our case, the price of buying puts; specifically protective puts. We follow daily the cost of protection in our Resource section. Readers can see the details of how this data is compiled on that document as well.

As the VIX moves, so does the cost of protection. However, on Monday, the cost of long-term protection went down, as expected with ah higher market day, but the VIX did not decline, it rose.

The short term nature of the VIX tells gives us more of a near term read on the market and when we see an up VIX day, we should expect some downward pressure.

Late last week presented itself as the cheapest opportunity to hedge since the beginning of November and with the SPX testing the 1260 resistance level Monday, many made the case for resetting their hedges. And they did. This was part of the reason options kept their higher than expected value.
These one day moves away from normal correlation will right themselves relatively quickly; and it will happen one of two ways.

1. The VIX drops confirming the rally in equities and reflects a reduction of fear

Or

2. The SPX drops to follow the lead of the options market and confirms that the hedgers were right to take advantage of the top of the range.

Up to you to choose, but given the choice, we pay more attention to the signals of the options markets and won’t count on the price of protection to stay this low.

Happy Hedging


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