Cost of Hedging Update 12-11

by Jay Pestrichelli on December 11th, 2012

At Tuesday’s closing option prices, we see the cost of hedging out 6 months the lowest it has been since we've tracked this stat every day for the last 17 months. The short-term hedging costs weren't too bad either with a drop to 0.92 bps per day as the mid-term price move to that new low of 1.13 bps per day.  That means that if you wanted to just buy a long put on the market out to June expiration it is only going to cost 2.1% or 4% annually.
See data for the past 17 months on our Resources Page
Some of this reflects the after hours price of the index futures that were on the rise, but in reality it is all due to the drop in volatility and the strong day in the equities market.
This isn’t the lowest volatility we’ve seen in recent memory either. In fact just as recent as November 30th, the VIX dipped below the 15 mark compared to the 15.57 close on Tuesday.
From a fundamental perspective there’s not a very strong case for the all-clear / take-on-more-risk signal. In fact the situation dictates just the opposite. However, the options market is not showing any signs of fear and protection is cheap cheap cheap.

At these prices, the market is actually daring you to go out and speculate. I will venture to state that the only reason why the VIX (an indicator of how expensive options are priced) is not at an all-time low, is that there are speculators out there that just can’t pass up on these cheaper than normal lottery tickets in the form of long calls and puts.
Perhaps it is that we are finally going to hear from Fed Chairman Dr. Bernanke Wednesday and the expectation is further easing (if that is at all possible). However gold prices didn’t reflect that sentiment as they were relatively flat. Typically gold will pop up when money supply is on the rise as it can act as a hedge against inflation.
This entire situation reminds me of one of my favorite Wall Street axioms:

“The market has the ability to act irrationally longer than you have the ability to stay solvent”.

This feels like one of those irrational times to me. To be on the eve of going over the highly publicized and over-hyped fiscal cliff and to see protection at its low just doesn't fit. It might be that the traders are playing the opposite of what ever other person thinks. When the masses line up on one side, it’s usually a good bet to take the other.
But here is something that I’d like to point to. The only other two times over the last 17 months we saw the mid-term hedging cost at a relative low point was on March 26th 2012 and October 5th 2012.  Those points are on the chart below. 
While they didn’t point to the exact day the market made a turn, in both cases the markets headed lower shortly thereafter. I’m not sure if this is the turning point or not, but it’s seems safe to say that on a relative basis this is an interesting data point to consider.
I know this all seems overly bearish, but it’s not mean to be. This opinion is more about the market’s lack of concern as seen by the unusually absence of normal rolling protection purchases and the recent history of when this situation existed before. This is not meant to spawn speculative bear trades, but instead to inform those hedgers our there that if you’re looking for cheap protection, we haven’t seen it lower than this in the past 17 months.

Posted in not categorized    Tagged with no tags


Leave a Comment