Adding Probability Data to Hedging

by Jay Pestrichelli on July 27th, 2012

As the market continues its mid-earnings bounce and presses up against a 3 month high, I thought it would make sense to look at some hedging data on the SPY. Many of our clients hold this ETF as a core position so watching how the costs and probabilities look is a good barometer for many portfolios.

Typically, we don’t discuss probabilities, but right now much of the annualized cost difference for the mid-term (2-5 months) and the long-term (6+ months) can be explained by the probabilities.

See the chart below:
For example, building protection at the 10% downside (123 strike) level for October will cost about 3.7% compared to building the same level of protection out to January 2013 that cost 4.8%. Granted, you are protected for twice the amount of time, but the cost is annualized so we would want the annual rate to be close to the same. But it’s not.

However, when looking at the probability of the market ending up below the 123 strike price at expiration, the chance is more than double: 10% vs. 21%. Compare similar probabilities, pricing starts to make sense. Look at the October 123 strike cost of 3.7% compared to the 116 strike for January that has a cost of 3.2%. The probabilities are closer in line of 10% and 9.7%.

Of course dividends are also a part of this equation, which is why we’ve included them in the table. Between now and October you will get one dividend and 2 before January 2013. The last 4 quarters have averaged $0.67, which can offset a decent part of the hedging prices. The market knows this and it is included in the prices of the puts.

If your outlook is bullish and you only want to protect against catastrophes, then going out to JAN’13 puts at the 110 level will only cost you $0.15 or 0.2%. I like to call that one a wash. While the probability of a 20% downside move to put that hedge in-the-money, is only 4%, it does let you comply with rule #1, which is Hedge Every Investment.

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