Cost of Hedging Weekly Update 10-9-13

by Jay Pestrichelli on October 9th, 2013

The uncertainty of how the debt ceiling debate will play out has finally reflected itself in the cost of hedging as we hit new highs for the year. As of the close of business on the 8th  the short-term daily cost was 1.27 basis points per day and the mid-term cost out to March 2014 rose to 1.44 basis points per day.  
 See data for the past 28 months on our Resources Page

 
Yesterday’s 1% drop in the market was the 11th down day of the last 14, but probably the one that was the most fear driven. The VIX had its second highest close of the year and the cost of hedging jumped higher to levels not seen in 2013. The last time these levels were seen was right before the Fiscal Cliff came to a head in late December.
 
If you haven’t been hedged through this, now is going to be more expensive to put on new protection than anytime of the last year. However there may be a glimmer of hope that may give you a chance to put some on today.
 
The bit of good news will be the appointment of Janet Yellen as the new Fed Chairperson after Bernanke’s term is up.  The markets are going to react favorably to her appointment, as expectations of low interest rates will persist. Not to mention her support of the QE program.
 
So how are we trading this market right now? The answer is we’re going to take advantage of this pop in volatility.  That means selling puts as a way of entering into new positions and rolling any short calls that have depreciated significantly over the last 3 weeks. Remember, just a few weeks ago, September expiration had some of us rolling hedges and selling new calls after the market just hit new highs. Much of that premium (from the short calls) has been realized so taking the quick gainers off the table isn’t bad if you’ve got a taste to sell them again.
 
I’ve been asked many times the past 2 days what I think will happen if we actually default on our debt obligations. There’s no precedent that I can recall where a government has defaulted on their debt obligations WHILE having the means to meet them. What we’re facing is not an Ireland, Greece, or Spain situation. The U.S. has the means and ability to pay its debt if it wasn’t for it being used as a bargaining chip. And although no one believes it can happen, the fact that people are seriously considering it is becoming evident in market movements and emotions are taking over. 
 
So since there are no past examples to draw on, I’ll refrain from a prediction except for that it would be bad. Very bad. Like 20% decline in a week bad. Like 50% over the next 6 months bad. It will be a structural failure that would cause the first wave and then the true panic would set in. Missing just one payment on a treasury would rattle the pillars of the U.S. economy and shake the financial stability on which it is built. (sorry for the drama)
 
But I remind our Buy and Hedge clients that this is why we buy protection and follow Rule #1: Hedge All Investments.  If you’re hedged the way we have taught you, losses will be significantly less in your portfolio and when it irons itself out in the next year, you’ll be poised to grow from a higher level than everyone else.
 
I’ll state for the record that I do not believe there is a chance of a U.S. defaulting on its debt. 0.0%. However, that doesn’t mean you shouldn't be hedged. There are plenty of other reasons why the markets can sell off. Just a reminder, earnings season is right around the corner.


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