Cost of Hedging Weekly Update 5-17-13

by Jay Pestrichelli on May 17th, 2013

A series of higher highs continue to define this May as the market pushes upward. The results of which are a maintained low cost of hedging. As of yesterday’s close the short-term daily cost was 0.70 basis points and the mid-term out to December dropped to 0.95 basis points per day.  
See data for the past 22 months on our Resources Page

Despite the S&P being 25 points higher now than where it was a week ago, the cost of hedging has ticked up slightly. The difference in the cost of hedging is minimal, but what is interesting is that it isn’t lower, as typically we’ve seen before.  Why you ask? I’ll share some insights on a discussion I had with one of our clients this week.
Imagine you have been long this market since December. That means you were bold enough to brave the worries of the fiscal cliff and held strong in the face of the sequester fears. Almost every day you would probably ask yourself if today’s new high was the time to sell. However you don’t want to try time the market and miss out on more of this run up. After all, you’ve been asking yourself that same question since the middle of March and you’ve been right to stick it out so far. However, you don’t want to be greedy and give it all back if there is a quick turn. So what do you do? The answer is you hedge.
Right now locking in gains with a hedge, vs. selling is a way to leave yourself exposed to the upside and limit how much you can potentially give back if the market turns south. The best way to lock in those gains is by buying long puts.  The cost of hedging at a level 10% below the market is 3.5% annually right now and this is the choice many investors are making instead of going to cash by selling. In other words, the worst you could do from here was to lost 13.5% if the market sold off by the end of the year.

However, if you want to tighten up those hedges, you can buy at the money puts for about 8% annually. They are more expensive than the 10% protection that cost at 3.5%, but if the market does correct, you keep even more of your gains for the year because you’re locked with the right to sell at these levels.
But there is also another factor that is keeping the longs long. It’s the taxable event of selling now. If you’ve been long for less than a year, the tax treatment is as short term capital gains, which is your income rate. Holding on to those gains for a year will yield a better return in your pocket after taxes by up to 20%. So ask yourself, does it make sense to pay 8% in hedging costs and stay long or sell now and incur a 20% higher tax bill? Before you answer, let me give you one more incentive to stay long…that is if the market does run up and your hedge never gets used, that 8% cost can be counted as a loss and carried over for when you do eventually sell. Convinced?
It seems right now, the answer continues to be stay long and hedge vs. selling and going to cash. This is a perfect example of the tail wagging the dog and how a good market can build on itself for no reason except is more efficient to stay long. 

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