Watching the Cost of Hedging to Time Protection

by Jay Pestrichelli on August 15th, 2012

As long-term investors that hedge every position, tracking the costs of protection is something we pay very close attention to. As a general rule, the higher the market goes and the lower the volatility, the lower the cost of hedging.  And right now, we’re sitting at some relatively low costs.

Using put options on the S&P, we track the daily cost in basis points of strikes 10% below the market. While 10% isn’t necessarily the best protection for everyone, it turns out to be the mid-point the average investor is willing to endure to the downside and makes for an easy apples-to-apples comparison.

We watch the short-term (75-100 days) and mid-term (150-225 days) costs of S&P puts 10% below the market and the chart below shows the picture over the last 13 months by day.
The figures behind this chart can be found on our blog resource page www.buyandhedge/resources

During October of last year, short-term costs spiked as the market bottomed, but as the market went on a 6 month run up of 30% through March, we can see cost o hedging declined steadily. 

But despite the market continuing its rise after Feb, the cost of protection stayed relatively constant from February to May hovering around the 1.50 bps/day.  Of course there are dips and pops like any index, and if you were savvy enough to time the purchase of hedges in late March, you could have bought protection much cheaper. But as all things with the market, timing is a difficult game.

One other note about this data, that the casual observer may miss; spikes in divergence between the short-term and mid-term cost have often occurred around market reversals. Separation in the green and blue lines above saw reversals of down markets occurring in late Sep 2011, and again in late Nov 2011. And although less pronounced, markets hit tops in late Mar 2012 and Apr 2012 as the short-term (blue line) saw separation from the mid-tem costs (green line). While its too early to see yet, the same divergence occurred last week and may indicate some downward pressure is in store for us.

While no one is ever excited to endure the cost of hedging while the market is running up, the benefit is that it gets cheaper. The opposite is true as well, as the market falls, hedging gets more expensive.

At Buy and Hedge, we pound the table on staying hedged, so choosing the times when costs are low at market tops helps us keep costs in line. This may mean rolling forward some protection earlier than expiration as we’ve been doing the last week. In other words, we're taking advantage of the lower costs and extending our protection. Perhaps it's something you'll consider as well.


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