Cost of Hedging Weekly Update 11-27

by Jay Pestrichelli on November 28th, 2012

As we battle through the final week of a bumpy November, the options market is showing us that there is nothing to fear. We say this because it appears that due to the low cost of hedging, many investors just aren’t looking to buy protection. The short-term costs have dropped below 1 bps per day and the mid-term costs are at the 1.25 mark again. Both are down about 15% from the last update we made.
See data for the past 15 months on our Resources Page
All of the cost of hedging indicators we watch are telling us its smooth sailing, which is surprising considering the big to-do fundamental investors are making about the fiscal cliff. This is a classic clash of technical and fundamental analysis and it’s what makes markets.
Indicator #1 Hedging Costs: The actual cost of hedging is approaching the lows we saw in late September / early October. This turned out to be a great time to put on hedges as the market was topping out looking forward to a Romney White House   Of course we know about the sell off form there and those that took advantage of those levels put hedges on that were shortly providing protection.
Indicator #2 The Short vs Mid-term Spread: This measures the difference between the short term daily cost of hedging and the mid term cost of hedging. Looking at this data for the 2012 year, we can see that when this seems to be a leading market indicator. Using either a daily or a 5-day moving average of this spread shows us that we’re just about at a high for the year. The last time we were this high was late August before the S&P ran from 1400 to 1470. 
Indicator #3 The VIX: We’ve said it before, the VIX is an indication of how much traders are willing to pay for a speculative bet. The VIX intends to show the implied volatility of the S&P 500 over the next 30 days. And right now we’re at a very low level. Anything under 17 is considered very moderate and that the option traders just aren’t foreseeing any big moves. Despite all the upcoming worries about the fiscal cliff, the option traders just aren’t projecting much movement in the short term.
All 3 of these option indicators seem to fly in the face of what the general investing population is thinking when it comes to the fiscal cliff discussion. Of course all of these turn on a dime when it fear steps into the market, so be careful to not use them in a vacuum. What we do take away form this is that if you fear a sell off, this is  a pretty good time to put on your hedges or roll them forward. The short term cost that will cover you through mid February are pretty cheap right now and if you fear the government gridlock won’t be done by then, they should pay off well.

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