Cost of Hedging Weekly Update 9-17-13

by Jay Pestrichelli on September 17th, 2013

September continues to fly up in the face of the bears and the cost of hedging has legged lower as a result.  As of the close of business on the 16th the short-term daily cost was 0.81 basis points per day and the mid-term cost out to March 2014 dropped to 0.96 basis points per day.  
See data for the past 26 months on our Resources Page
 
It’s been a while since we described what the cost of hedging means, so we thought we’d do a refresher course today. The concept is that you can protect a large amount of your portfolio by purchasing a put on the S&P 500. We call this a portfolio put and each contract will protect about $150,000 worth of value. Here’s a description from our book, Buy and Hedge.
 
The portfolio put is when an investor buys an index or sector ETF
put to create downside protection in the event of a broad market correction.
In other words, it appreciates in dollar value when the market
declines—hopefully offsetting your portfolio loss dollar for dollar (or
close to it). This kind of hedge can cover an entire portfolio value
or just parts that aren’t already hedged. The hedge is simply long
puts on an index that aren’t married to a specific position but that
are designed to kick in and hedge as soon as the broader market has
declined enough. Think of this tactic as an umbrella insurance policy.

 
This weekly update reviews the relative cost of purchasing a portfolio put via S&P 500 index options at a level 10% below the current market price. We track the cost of hedging to watch for opportune times to add protection or to assess if the market is overly expensive. In addition, you’ll notice that we look at 2 different time frames, a short term of about 3 months out and a mid-term of about 6 months out.
 
Typically, we like our long portfolio put to cost less than 4% annually or less than 1.10 basis points per day. (100 basis points = 1%).  Between this low cost and selling calls or puts to generate income, we think the drag of the cost of hedging is low enough to make it worth while to do.

Often the cost of hedging is criticized as too prohibitive and will always put a drag on returns. However, when done at a low enough percentage, it is very much worth your while when the market decides to correct. Between dividends and call selling, we think you can keep the cost of hedging to 0% most of the time. Using portfolio puts, like the S&P options we track here, far enough out-of-the-money managing costs can prevent hedging from hurting returns in the up years and create stabilization in the down years.


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