Cost of Hedging Weekly Update 9-20

by Jay Pestrichelli on September 20th, 2012

What a difference a week makes. As of yesterday, 9-19, we saw short-term (3 months) protection costs hit the lowest level we’ve seen since we began tracking it.  The mid-term (6 months) costs is also tracking dramatically lower.
As always you can check our Resources page for the detailed data
While the market rise to nearly 5-year highs is of course a big driver of the lower cost, we know volatility is a better reflection of how these costs are determined. But there is something this time around. A month ago on Aug 13th, the VIX closed at 13.7 and the near-term cost of hedging was 1.24 basis points a day. Yesterday the VIX closed at 13.88 and the near-term cost of hedging was 0.82 basis points? Why the difference.
We believe there are two reasons why.
First, the market is higher that it was in mid August. The S&P 500 is trading at 1465 today compared to the closing price of 1404 on August 13th. Higher markets can, we stress CAN, drop the cost of hedging.
The second is a reason we rarely talk about and that is the impact of volatility a few months out. We’re talking about the VIX futures. While the VIX is a mathematical representation of the implied volatility of the S&P 500 options, the VIX futures are speculative instruments that look to forecast where the VIX will be many months away.
As an example, the December and January VIX futures that are out 3 and 4 months are quoted at 19.4 and 21 respectively. However back on August 13th, the 3 and 4 month out futures of November and December were quoted at 22.1 and 23 respectively.
This drop has lead options traders to lower their expectations of volatility over the next few months. But I’ll remind everyone, this doesn’t mean the markets are only going up from here. Situations like this, where everyone is on the same side of the volatility trade, can lead to violent whip-saws and catch those squeezing that last bit of juice from the fruit with too much exposure.
For hedgers, this is the kind of opportunity we like. In other words, while the markets are hitting new highs, the price of insurance drops.  If you’ve got some laddered protective puts that are expiring, rolling them up to a higher level is an affordable and timely idea.

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