Historical Cost of Hedging

by Jay Pestrichelli on March 23rd, 2012

As hedgers, one of the most important metrics to manage is the cost. We understand that knowing your risk metrics is of the utmost importance, but as investors, we need to be as efficient as possible when it comes to impact on returns.

As a proxy for the cost of hedging, we track the cost of SPX puts at strikes 10% below the market. We post that data on a regular basis on the Resource Page and if you follow us on Twitter @buyandhedge, we tweet whenever this sheet is updated.

Here is how it works

The first thing we consider is Downside Percentage. If you’ve read our book, Buy and Hedge: The 5 Iron Rules for Investing Over the Long Term, you know that Downside Percentage (DP) is the amount you are willing to let the market decline before your hedge kicks in and have some value at its expiration. Think of this as the deductible for your car insurance.

We use 10% as the general rule for DP, but this is not appropriate for everyone or every investment. For example, we hedge long-term bond positions much tighter, around 4-5% and individual stock positions between 15-20%. However if you’re considering using a portfolio put, a single put that provides protection for the entire portfolio, then we typically set those protection levels from 8% to 12%.

Although not the same as insurance, put protection has some similar characteristics. Specifically, the more protection you want, the higher the cost; the lower the DP, the higher the premium of the put options. We keep that in mind, but for this exercise we use the 10% mark as a constant.

Now that we’ve defined our risk (10% downside percentage), its time to look at how much this protection is going to cost, also known as the Cost Percentage (CP). This number takes into consideration the amount of protection, the days of coverage and the price of the put. For the purposes of tracking historical values, we break it down to a daily cost.

Finally, we track short-term and mid-term put costs to get an idea of the difference in pricing based on the length of time coverage. This can be helpful when determining the length of time to establish protection.

The Data

As said before, we track the daily data and compare it to the S&P 500 (SPX) and the relationship to the Volatility Index (VIX).
Put Protection Daily Cost vs. the S&P 500
Put Protection Daily Cost vs. the VIX

The first thing we call out is that there is an inverse relationship to the SPX and a strong correlation to the VIX.

This isn’t surprising considering that as the market looks stronger, less people are trying to buy insurance. As the market gets choppy, more investors are buying protection, which is why we saw the high in costs in early October.

Currently we see that short term protection is at low but has started to define a channel despite the SPX continuing its rise. For example, the costs have not dropped much lower than the Feb 3rd low when the SPX was trading at 1345. As the SPX rose to 1400, we see that the price of protection didn’t decline…actually at times it rose.

Keep in mind that as the volatility levels out, the price of the options will as well. While the VIX can go lower and has been below 10 in the past, right now the market seems to be putting in a floor around the 15 level. If this holds true, don’t expect the cost of protective puts to drop much further.

At the very least, we can assess that on a relative basis, it is cheaper to hedge now, than it has been over the last 8 months.

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