Cost of Hedging Weekly Update 3-5-13

Posted on March 5th, 2013

Right after we posted our weekly update last Monday the market did a 180 on everyone, well at least for one day. After the Monday Feb 25th 1.8% sell off the cost of hedging popped almost 60%. But since we drifted back down to the historically low levels we’ve seen all year. As we stand  this morning the short-term costs stand at 83 bps per day and the mid-term costs have dropped to 100 bps per day. 
See data for the past 19 months on our Resources Page

 
As we press up against new high for the DOW today, the cost of hedging continues to stay low. One of the great ironies of hedging is that as the market goes higher, the cost of hedging gets cheaper. While that may make sense while it is happening, in hind sight, we’re always amazed that it wasn’t obviously costlier. Meaning we all go, "I could have hedged for less at the high and locked in gains for a lower price"
 
Let’s take a look at what happens if we get the “once every 5 years sell-off of 20%” this May. We’ll look back at March and April and say wow, I should have locked in my gains back then. Sure, we could have said that back in December 2012 and now today felt like we wasted our hedging dollars as the market has moved up 7% over the last 2 months. But the great thing about cheap hedging in rising markets is that the insurance was low to start with.  
 
The way we combat the thought of “I bought my hedges too early and the market moved up anyway”, in part, is by laddering our protection. This means we don’t buy all our put protection for the same month; instead, we stagger in out across multiple expirations. As it expires we roll more higher capturing in more of the underlying appreciation.
 
Back in October, before the election we talked about moving a lot of our hedges out to March in case the fiscal cliff did cause the sell-off some feared. That sell-off didn’t happen so the cost hedging gets chalked up as a loss. Here’s what that trade would have looked like back in October: purchased a March 1300 put on the SPX for $2800 to protect $130,000 of portfolio value.  Today that trade is basically worthless and we take the loss of $2800 or ~2%. However, the market has appreciate much more that and it may be time to lock in new levels.
 
Today we can roll up that put to a higher level of around 1375 to protect a downside movement of ~10% and that trade will run us about $2500. If the market runs up, it will be a loser as well, but if it pulls back, we’ve now raised our limit to 1375 vs. the 1300 from before.
 
For our clients, we’ll be moving our puts to higher levels this week for any March or April expiration. That doesn’t mean we think the market is going to turn, it just means we want to lock in the gains that we’ve experienced to date. Expirations will vary, but we’ll look to lock them in through September at the least as we're hedging for the long term.


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