Cost of Hedging Weekly Update 10-24

by Jay Pestrichelli on October 25th, 2012

What a difference a week makes. As the market has sold off 3.5% in just the last week breaking through its uptrend, the price to buy puts on the SPX 10% below the current price has shot up. Mid-term costs have popped to 1.5 bps per day level and short-term above the 1.25 bps per day level.
 
These levels are the highest since early September when the SPX was finding support at the 1400 level and we expect that level to be tested again in the near future.  That’s not a stretch since its only 8 points away, so the question becomes will that level hold?
 
As we don’t like to make direct market predictions here at Buy and Hedge, we won’t try to make this call; however we will point out that if the market does start to leg down, you’re going to want to have some protection in place. If the market does indeed sell off as the dreaded Head and Shoulders pattern forms (blog post from 10/12: Inflection Point), you can expect the cost of hedging to get to mid April and Mid July prices of about 1.80 bps per day.

This isn't a big jump from where we are now, but what concerns us is if the market goes through a 3 to 4 months of retracement and we get to the high hedging costs of the year we saw in May and early June. At that point, you can be looking at a 7% annualized cost of hedging that makes hedging expensive.
 
See data for the past 15 months on our Resources Page
 
From our perspective we feel costs are still closer to the bottom end of the spectrum when putting on hedges than near the highs of the year. So we’re still following the prescription and disciplined approach of putting on hedges for all positions, whether they are relative or absolute. The risk of over hedging at this point just isn’t a factor. SPX at 1300 may be another story and too costly.
 
With big events just around the corner of earnings, elections or expiration of tax breaks uncertainty is finding its way back into the market place. 


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