Portfolio Put Report 8-21

by Jay Pestrichelli on August 21st, 2012

The past few weeks we’ve outlined our observations about the cost of portfolio hedging, so this week, we’ll help draw some obvious connections to the VIX.

In general, portfolio put protection is at a relatively low level. We discussed this last week in our post last Wednesday: Watching the Cost of Hedging to Time Protection and the same environment continues to exist. We’ve actually been pounding the table on how from a historical perspective, hedging costs are at a low.

The inverse relationship between the S&P 500 and the cost of hedging is easy to see. But even more correlated is the direct move in the VIX compared to hedging costs.
As always, you can find the data that created this graph on our resource page.

In order to understand why the VIX represents more of a reflection of the protective put costs it helps to understand what it represents. The VIX is meant to be an indicator of the Implied Volatility of the S&P 500 options over the next 30 days. And in order to do so, it uses the near and next month at-the-money options of the SPX (S&P 500) as a means of determining its value. So naturally the cost of puts is a contributing factor to the VIX calculation.

This value is typically referred to as the “fear indicator” and when it drops, the common assumption is that the market has confidence.  However, when the VIX, starts to drop, it doesn't mean the market is necessarily less fearful. It also means it is less greedy (if there is such a thing). This is because it is less willing to pay more for speculative moves. Or said another way, it means that the market has experienced a lower chance of large swings in either direction. Perhaps it’s easier to think of the VIX as the surprise factor.

When looking at the chart above, we can see that despite the VIX dropping to new lows, the price of the portfolio puts has stayed relatively level. This is because of the time difference between the near term S&P500 IV and what the options are going for in the months further out.

Said another way, the market is not expecting volatility to stay this low and the farther out you go, the more it is charging for protection.  This divergence has happened before and as soon as there are signs of a pull back, expect the VIX to pop right back inline with the cost of hedging.

For now, we’ll enjoy the new highs and take advantage of the low cost of protection because the market tells us it won’t be like this forever.


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