Cost of Hedging Weekly Update 9-6-13

by Jay Pestrichelli on September 6th, 2013

The first week of September is looking stronger than the bears thought, but contrary to conventional reaction, the cost of hedging has stayed within its uptrend. As of the close of business on September 6th the short-term daily cost was 1.02 basis points per day and the mid-term cost out to March 2014 rose to 1.17 basis points per day.  
See data for the past 26 months on our Resources Page
Last week we posted how despite September being one of the historically worst trading months, it may be an opportunity for the contrarians to make a play against the crowd. Well the first 4 days have been slightly positive and the S&P has risen 1.4%.  However, the cost of hedging has stayed within an upward channel as you can see in the chart above. Both the mid-term and short-term cost of hedging have maintained their levels which leads us to believe the options market isn’t buying into these slight gains.
So if you’re putting new money to work, hedging is going to cost you more today than it did in the beginning of August. Not surprising that fear is creeping back into premiums considering August was the worst month since May 2012 for stocks.  However, if you had hedged on say July 31st while the VIX was still below 14 it would be paying off.

On July 31st the SPX MAR2014 1525 put could have been bought for $37.80 and today it is trading at $41.20.  While this isn’t very much of a profit ($340) it goes to show that the hedge is holding its value against the broad market as intended. From a probability perspective, the likelihood of this March 2014 put going in-the-money was about 29%. Today, despite over a month of time passing, the chance of the market going below 1525 by March 2014 expiration has actually risen slightly to 31%.
This rise in probability is reflected in the price of the options. The more likely the option will go in-the-money, the higher the premium. For example, on August 30th when the SPX was at the recent low of 1633, the premium of this option was over $50 and had a 36.5% chance of going in-the-money. For comparison purposes to the data at the beginning of the post, if we were hedging today at the 1500 level, the probability of the market dropping down 10% by March of 2014 is about 28% or about a 1 in 3.5 chance. 

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