Cost of Hedging Update 5-2-13

by Jay Pestrichelli on May 3rd, 2013

Welcome to May, the month that has showed losses since 2009. Day 1’s sell off was met with a new high on day 2. Perhaps this is the year that May has a turn around? According to the options market, it’s still an unknown and hedgers aren’t buying an uptrend just yet.  I'll explain in a minute.

As of yesterday’s close the short-term daily cost was 0.72 basis points and the mid-term out to December was 1.02 basis points per day. These points are virtually unchanged from last week’s report. 
See data for the past 22 months on our Resources Page

An interesting divergence is occurring between the VIX, the Cost of Hedging, and the S&P 500 index. Typically, the way the VIX goes, is the way the cost of hedging goes. Meaning the cost of hedging is more closely tied to the volatility component of the option prices than the movement of the underlying index. So a lower VIX means a lower cost of hedging…typically. 

However, right now we are seeing a rising trend in the VIX.  Ever since the VIX put in its low on March 14th, it has been in a trend of higher highs and higher lows. This is in spite of the S&P 500 putting in all time new highs. See the chart below.
This isn’t all that uncommon. The VIX, which is incorrectly described as the fear index, can trend slightly up when the market approaches new highs. That is because the speculators and the hedgers alike are preparing for what they perceive to be an inevitable drop.  Let’s face it, all that “Sell in May and Go Away” stuff had to get some people looking for protection and locking in profits.

But what illustrates this trend the most is where the VIX closes on the days that the S&P hits a new high. The scatter chart below shows that since March 14th, the VIX has been closing higher each time the S&P has hit a new high. In fact, the lows of the VIX today are at the same levels it was at the beginning of the year. At that time the S&P was trading at 1460 compared to the 1598 it closed at yesterday. 
Stepping back, let’s evaluate this. Any sell off will surely send the VIX shooting higher, and this gradual climb upward has put us in the zone where option prices are rising on a higher expectation of a pull back. While I don’t have a crystal ball, it’s hard to imagine much of a situation where the VIX doesn’t rise from here…at least in the short term. We’re going to watch to see if the VIX can close above 14 on one of these new S&P 500 highs as confirmation.
 
Here’s the gift of all this; the cost of hedging so far has not risen in kind by any notable amount. In fact we’ve stayed under a 4% annualized cost for quite some time now. It’s rare for us to propose this, but hedging with puts closer to the money might be an interesting alternative than what we typically suggest. Near or at-the-money puts are more expensive, but the rate that they appreciate when the market drops is superior to the 10% out-of-the-money puts we normally watch.  
 
This relationship of the rate of change in option price compared to the change in underlying price is known as delta. This is probably one of the more common option Greeks referenced and it helps us understand how our hedges will react in a rising or dropping market. For example, an ATM put might have a delta of -0.50. That means that ever point the SPX goes up, a put goes down $0.50. Conversely, every point that the SPX drops, the put goes up by $0.50.  That makes these great hedges. Eventually that rate of change approaches either 0 .00 or 1.00 depending how far the option is in or out of the money.

The options we normally refer to at 10% OTM typically have a delta of -0.30. This means it takes a larger decline for our options to pay off compared to an ATM put. However the cost of the OTM put is significantly cheaper. If our expectation is for the VIX to rise, that means put prices will also tend to rise. This gives us a little room to be wrong and more of a chance for our long protective put to pay off.
 
The market isn’t quite fearful yet, but poised to get there. Think of this as a coiling spring. Right now, the pressure may be building up and we should expect it to continue. In front of almost every sell off comes a rising VIX and if we are poised for the VIX to naturally rise in either an up or down movement, it seems like the right time to be buying it.
 
We’re going to watch for the VIX to close above 14 on one of the S&P 500 new highs to give us the green light that this volatility uptrend is in play and to tighten up our hedges in preparation for a dramatic spike in puts values.


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