Cost of Hedging Update 10-2

by Jay Pestrichelli on October 3rd, 2012

 As a reader of the Buy and Hedge blog, you know that managing the cost of hedges is just as important as understanding your risk.  This weekly update is not meant to give advise on timing, but to give an understanding or the relative cost of hedges and to try to explain some of the dynamics that drive its change.
This week, hedging costs returned to lower levels with short-term rates at 0.97 daily bps and mid-term costs at 1.25 daily bps. You can see all the historical data on our Resources Page.
Last week’s update, Update 9-26, we talked about Spain’s troubles reared their ugly head and causing the markets to jump in volatility. That update reminded us that it was not too late to hedge as costs, while off their lows, were still affordable. It also reminded us that when volatility jumps, selling calls generated a higher premium and to take advantage of that.
This week, the cost of hedging pulled back to some lower levels despite some down market days. The negative of this environment is that it is getting harder and harder to generate income off selling options. Whether you’re putting on a spread or collar, the upside options for October just don’t have the juice to generate premiums. By the way, November options seem to have a little extra premium in them, but we believe that is attributable to the election.
When a situation like October's low option prices occurs, don’t force it. You can wait or if put protection is cheap enough, just use the protective side for the hedge. In other words, it’s not always necessary to sell calls. Sometimes just holding the puts (i.e. married put) can work. This tactic does have the advantage of not limiting your upside and still providing downside protection. Most of the time it is too expensive to put on just a long put (greater than 3% on an annualized rate), but watch for it to happen. Right now this is not the case for the SPX, but it may be for some ETFs or individual stocks.
An example of this would be Johnson and Johnson (JNJ). Currently at $69.25 a 10% downside hedge would put us roughtly at the 62.5 strike. The April 62.5 puts, 198 days away, trade at 0.80. There’s a few ways to calculate this annualized cost, but the easiest way is to simply divide .80 by 69.25 (to get 1.15%) then annualize it by (365/198 * 1.15%) to come up with an hedging cost of 2.12%.
Add to the equation that JNJ has a dividend yield of 3.52% and you’ve got a position with unlimited upside and downside protection of 10% that is more than paid for by the dividend with money left over to spare. In this situation, there is no reason to sell calls as a means of offsetting hedging costs.
This was not always the case for JNJ. Look back to this day last year when JNJ was trading at $62. The April 55 puts (11% downside for 200 days out) were trading at $2.70.  This is a 7.95% annualized cost to hedge and is way to expensive to endure without an offset.  Of course in this situation, we would want to sell calls to offset that married put cost.
JNJ is obviously a stock with low volatility, which makes hedging more affordable. The point of this post is not to go buy JNJ, but get you familiar with understanding the importance of managing your hedging cost and watching for the right environment to put it on. We still are of the opinion that these are relatively low costs and have been taking advantage of it.

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