Cost of Hedging Weekly Update 6-26-13

by Jay Pestrichelli on June 27th, 2013

The upward trend in the cost of hedging continues along with the rise in volatility. As of the close of business on the 26th the short-term daily cost was 1.21 basis points and the mid-term cost out to January rose to 1.38 basis points per day.  
See data for the past 24 months on our Resources Page

No coincidence that the cost of hedging is rising as the market is selling off this month. Actually, the rise in the cost of hedging began in early May giving us some hint that the end of the rocket climb might be upon us. On Monday we hit new hedging cost high for this calendar year as the markets’ sell off continued from the previous week. You can see that spike in the chart above.
We also saw the short-term cost cross higher than the mid-term cost and this is typically a signal for down days ahead. Although it doesn’t last long, this phenomenon is caused by short-term speculators trying to play a quick swing in the market. They end up bidding up the price of near-term options and not the longer term ones. When they sell those speculative options, it drives the option premiums lower and normal environments continue. It’s tough to tell if we’re out of the woods there yet, but I’d look to previous support levels in the stock market indexes to provide resistance for further selling.
Use the 50-day moving average as a level to watch.  It has provided support all the way up this calendar year and will be a test to see if the market has forgiven The Fed yet for hinting at tapering.
So is this a good level to hedge? Should you be putting new money to work here in equities? At Buy and Hedge, we aren’t market timers, but we do pay attention to when stock, bonds, and options appear to be mis-priced. So in choppy times like we’re in now, we are putting half of new money to work and selling puts 5% below the market for the other half.  This allows us exposure to the upside, but keeps some powder dry for ugly days. This is one way of being a disciplined buyer on the dips.

We’ve also been telling you now for months that the cost of hedging was uncharacteristically low and quite frankly; we’ll be surprised if we see it touch the lows of May again this year. However, that doesn’t mean don’t hedge.  Keep Rule #1 in play: Hedge Every Investment

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