Cost of Hedging Weekly Update 5-30-13

by Jay Pestrichelli on May 31st, 2013

This past week’s volatility (I say that slightly facetiously) has started to move the cost of hedging a little higher. As of yesterday’s close the short-term daily cost was 0.78 basis points and the mid-term out to December dropped to 1.06 basis points per day.  
See data for the past 22 months on our Resources Page

As you can see from the chart above there is a slight trending up in the cost of hedging since the beginning of May. It is showing itself more in the mid-term costs, as yesterday hit a level of 1.06 basis points per day - a level not seen since April 19th.

When charted against the VIX, the correlation is pretty obvious. As the VIX goes, so does the cost of hedging. This of course makes sense as the VIX reflects the volatility cost component of the SPX Options. See Below:
Of course they don’t have a 100% correlation, but the general trends are very closely aligned. As a reminder, the VIX intends to show how expensive how options are going to be over the next 30 days. So a rise in the VIX means that the cost of buying calls and puts are on the rise and that is what is impacting our cost of hedging.
However, we hedge for longer than 30 days at a time, so there can be a divergence from time to time of the two metrics. The cost of hedging in the short-term may drop or rise at a different rate than the VIX as we saw last week.  In general, though, hedgers and speculators alike will use the VIX as a means of assessing how expensive options are.
Back to our point about a rinsing cost of hedging. If we see the cost of hedging rise, it may not necessarily mean the end of this bull run is near. It simply means that options are getting more expensive. That can come in the form of more traders buying puts to play a pull back or in the form of call buying in anticipation of another leg up. A higher VIX isn’t necessarily a bad thing for hedgers either. It means we can sell options for a little more income and help offset the cost of hedging. But make no mistake, this is still a very low cost of hedging environment and we like that as we want to manage that expense the best we can.

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