Cost of Hedging Weekly Update 6-6-13

Posted on June 6th, 2013

Another week of volatility and market declines has pushed the cost of hedging to the highest levels of the year. As of the mid-day mark on 6-6 the short-term daily cost was 1.18 basis points and the mid-term out to December dropped to 1.27 basis points per day.  
See data for the past 22 months on our Resources Page

This week has seen a pop in the short-term cost of hedging by 50% and the mid term by 25%. Those are notable moves and are reflective of the over 5% sell off we’ve seen in the past 10 market days.  The question most are asking is if this retracement just a part of the normal upward trend, or is it just the first leg of a longer pullback?
 
From our perspective it appears that it is starting to feel like the hedgers aren’t the only ones buying puts right now, but the bears are starting to make their speculative trades. We say that because the short-term cost of hedging is increasing at a much faster rate than the mid-term.
 
Last week we talked about the rise of the VIX and its relationship to the cost of hedging. That continues to hold true as it has jumped 25% in this short period of time.  So even though the VIX aims to project only 30 days out (a very short time period) it has not risen as quickly as the short-term cost of hedging.
 
In fact the short-term cost of hedging is almost as expensive on a daily basis as the mid-term cost. Historically, when those two data points have swapped, it has been an indication of some very near-term choppiness in the markets. We’re not quite there yet, but we’re watching it closely.
 
All of this boils down to a conclusion that in the short-term (100 days or so) the options market is looking to take advantage of some downward movement, while the longer term investors have either bought their protection or aren’t as concerned.
 
As market participants who hedge every investment, we have been protected this whole time, so we’re not running for the hills to liquidate. In fact our recent rolling of hedges turned out to be fortunate timing as we were able to lock in some more of the gains before this pullback started. But I’ll emphasize that was not a result of market timing. It was a result of our disciplined approach to hedging; which we will always advocate.


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