Cost of Hedging Weekly Update 7-17-13

by Jay Pestrichelli on July 17th, 2013

With the market rising to hit new all time highs, the cost of hedging decline of July has continued. As of the close of business on the 16th the short-term daily cost was 0.85 basis points and the mid-term cost out to January ticked down to 1.00 basis points per day.  
See data for the past 24 months on our Resources Page

The new high on Monday pushed the cost of hedging lower, but not as low as it was back in May. As we wrote last week, this is in part because of the expectation of rising interest rates and the impact of rho. But it is also in part due to the VIX not being as low either.  Back in April and May, the VIX had a 12 handle vs. the 14 we saw at yesterday’s close. 
Expect earnings to be the name of the game for the next month or so. With some trickling of info this week and the real thrust of data beginning next week, we expect the dialogue from the talking heads to move some focus from the Fed to corporate revenue and forward guidance data points.
The month of July is certainly off to a strong start with a 4.3% rise. Just 2+ weeks ago the S&P 500 was at 1606 and yesterday closed at 1676.  Believe it or not, the options market is actually giving you a little chance to play the up and downside for a relatively low cost. Here is how a short-term trading strategy might look (I admit this is a little of my inner guru coming out).
Using an ATM straddle (buying a put and buying a call at or near the money), you can create a position that gets you exposure both ways for less than $100 for October’s expiration. As of yesterday’s close, purchasing the 1675 call and the 1675 put would cost about $96. That means the trade makes money if the market expires below 1579 or above 1771 or 5.7% in either direction. Of course if the marked doesn’t move 5.7% this trade will lose money.
I would consider this to be a tight range for the volatile August/September periods we’ve had the past few years and may be an easy way to hedge it AND give you a chance to profit if this dramatic upward run continues.
The great thing about this strategy is that it gives you flexibility in the way it is managed. I don’t typically buy straddles and let them run like we do with say long put protection. With straddles, you can take some profits off the table early by selling one of the legs or by selling a shorter term option to generate a little income while waiting for the market to move. Straddles can easily turn into condors or back ratios spreads giving the trader plenty of choices on how to efficiently maximize profits. It all starts with buying the long legs while they aren’t very expensive as we are seeing now.

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