Cost of Hedging Weekly Update 6-19-13

by Jay Pestrichelli on June 19th, 2013

Despite the choppiness of the previous week and a half, the cost of hedging has declined due to the last two days of gains. As of the close of business on the 18th the short-term daily cost was 1.08 basis points and the mid-term out to December dropped to 1.12 basis points per day.  
See data for the past 22 months on our Resources Page

The S&P 500 rose to over 1652 after yesterday’s close.  The last time the S&P 500 rose over that psychological mark on May 14th there seemed to be a different vibe in the market. No one was talking about tapering and interest rates hadn’t gone haywire; all seemed to be OK with the continued move up. Let’s compare some of our key cost of hedging data points between the last two times the market crossed up over the 1650 mark:
A few things jump out at me despite the market being at virtually the same value.

First, the cost of hedging in both time frames is notably higher. The Short-term is higher by more than 56% as it jumped from 0.69 bpd to 1.08 bpd. The Mid-term is also higher, by a mere 23% as it moved from 0.91 to 1.12 bpd

Second, the VIX is higher by 30%; going from 12.77 to 16.61. This is a great example of how the VIX itself  varies from the price of the Index. So despite the index being virtually the same AND going in the same direction (up), the VIX is notably different. This is why we use the VIX as it gives us some insight into the thoughts of the options market.

Third, the difference between the cost of the two time frames. The Short-to-Mid term difference in the cost of hedging has historically been an indicator of the speculators vs. the hedgers. The lower the Short-term daily cost, the less speculators are looking to gain from a quick move. Said another way, when the Short-term CoH closes the gap on the Mid-term (or even passes it), it tells us that the speculators are willing to pay more in option premiums because they see more of a chance for larger market movements in the near term. Usually they see more of a chance for a sell-off, but not always.
 
Putting these three points together, leads me to believe the options market is getting skittish and is less trusting of the move up we had these past few days than the confidence it had back in May. If the cost of hedging gets too high, investors looking to lock in profits will decide to sell rather than buy hedges. This will add downward pressure to the markets compared to the alternative we had previously where it paid to just hedge and keep the exposure to the upside in place.
 
One last point to make here. The mid-term option we’re quoting today is the same one used back on May 14th. The DEC13 1475 Put could have been bought for $30 on May 14th while the S&P was at 1650 with 219 days to expiration.  Today that same option is trading at $31 despite only 184 days to expiration as more than a month has passed.  In essence, hedgers got a free month of protection this past month. This is due to the rising of volatility whose premium increase outgrew the time decay and kept the position neutral.   That’s a nice gift for hedgers, so enjoy it…we may not get a chance at it for a while.  Hopefully now you’ll be able to see what those opportunities look like if they come around again…hint hint – a low VIX can be a hedgers best friend.


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