Cost of Hedging Weekly Update 2-25-13

Posted on February 25th, 2013

Last week gave us something interesting to write about when it comes to the cost of hedging. The continued push higher reduced costs and quickly reversed in the wake of the two-day sell-off.  Here are the numbers: the short-term cost of hedging hit as low as 0.59 bps per day and the mid-term to 0.91 bps per day.  
See data for the past 17 months on our Resources Page
Timing when to put on your hedges is a little like trying to time the market, it’s tough to buy exactly on the bottom.  But the good news is that there are some tools you can use to help you know when the costs are cheap or expensive on a relative basis. The first thing you need to know is how to calculate the cost of hedging. Luckily as a reader of this blog, we do it for you right here and if you go look at the data in the link above, you’ll even see the equation we use.
The second tool is following the right data on which the cost of hedging is tied. Those are volatility and price movement the underlying asset you use to hedge. We use the S&P 500 as a proxy for the market, but any index will do. The S&P 500 index and its volatility component, VIX, combine to create a range where the costs will stay. Right now, the higher the market presses, the lower the costs, but this is not a 1 to 1 ratio. The VIX will move in relation, but not negative 100% correlation to the markets. For example, right now the market is slightly up and so is the VIX. Typically they move in opposite directions. When this happens the VIX, which reflects how expensive options are, will have a larger impact in the hedging cost. In this situation, it will push costs slightly higher.
What has been so interesting about the moves of the last 2 weeks is that the VIX’s move has been more dramatic than the S&P 500. This comes back to our thesis from a few days ago where we discuss that the cost of hedging is so cheap, it is preventing a market sell-off. Those worried about a correction don’t want to take the risk that they miss more market appreciation by selling stocks, so they just buy cheap short-term protection instead.  When this change begins and hedging becomes too prohibitive, expect the normal selling pressures to return. That seems to be where we are going now.
VIX above 15 should bring short-term protection costs closer to the .80 bps per day range or about 3% annually. That will start to be too much for those looking to protect profits and the tendency will be to sell their holding rather than hedge them.  This is clearly a tail wagging the dog scenario and don’t expect it to last. As longer term hedgers, we take advantage of this situation and lock those lower hedging costs in for the rest of the year.

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