Lesson of the Year #1: Volatility and the Benefits to Hedging

by Jay Pestrichelli on January 10th, 2012

If there’s one thing that investors learned about this year was extreme volatility. The market saw prolonged periods of an elevated VIX (Volatility Index) and experienced some of the most wild day-to-day swings the market has ever seen.

Volatility never reached the highs of 2008, not by a long shot, but the dramatic daily change in market direction probably caused more confusion than any period in 2008. Let’s face it, in 2008, it was a race to the bottom. In 2011, no one was sure which way the race was going.

As hedgers, this made life particularly interesting. As late as July 22nd, the cost of hedging was low and using married or portfolio puts made economic sense. There was no real value to be generated from selling away upside potential. Fast-forward just a few weeks to August 4th and WOW, the environment changed dramatically.

Short-term hedging costs went from about 1.25 bps/day to 4.2 bps/day in just two weeks. That’s a triple increase in price in only 2 weeks. You can see all the daily data for mid and short-term portfolio put costs on the resource page.

We know that the cost of protection is inversely correlated to the market. Seen in the chart below, as the market goes down, the cost of protection rises.
This phenomenon is driven by fear of additional losses. When confidence is lost, fear goes up, and when fear goes up, protection gets expensive.

It insinuates that investors feel a drop means more drops are on the way and not that they will try to pick bottoms. This couldn’t be farther from the truth. Historically, the markets have fast declines and slow recoveries. Yes, the bears and shorts pile on like gangbusters when they feel their strategies are poised for success, but those strategies are short lived.

The opposite is true for up markets. When the market is on the rise, hedging becomes cheaper. Kind of like why a good driver gets a lower insurance premium. This is also contrary to the market behavior. Markets go up and down. Investors are taught to buy low and sell high. So when the market goes up, shouldn’t we expect a pull back and shouldn’t that increase the cost of protection? Good thing for us, this isn’t the case.

The point is that this inconsistency in the market’s cost of hedging and the bias of investors gives us a great opportunity to get our hedges cheap when the market is up and a chance to capitalize on our underlying when the market is down.


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