Cost of Hedging Weekly Update 11-26-13

Posted on November 26th, 2013

Another week and another all-time high for the S&P, and the lack of interest in hedging persists.  As of the close of business on the 25th the short-term daily cost was 0.60 basis points per day and the mid-term cost out to June 2014 was 0.94 basis points per day.  
See data for the past 28 months on our Resources Page
 
With such little volatility in the markets, the bulls have a lot to be thankful in November. The cost of hedging has stayed in a very tight and LOW range compared to historical rates. And as discussed last week, there are a few theories out there that tell us the low cost of hedging will continue to keep the bulls long.
 
However, that phenomenon can turn around quickly. While it is difficult to find the cost of hedging being reported in the financial media, a good rule of thumb is to watch the VIX. If the VIX can sustain a level over 20 the price of protection will also rise and possibly to the point where the skittish money decides to sell their holdings vs. just hedging it.  Although there isn’t 100% mathematical correlation, the cost of hedging would rise about 50% from here if the VIX was to pop to the 20 level. At that point, investors may just decide to lick their wounds by cashing in their hedges and selling their long holdings. This would be because the cost of hedging is high enough now that it would not make sense to re-hedge.
 
This is all theoretical, of course, but it stands to reason that once any decline puts a real scare in the market it will manifest an additional wave of selling as hedges expire. Until that point, we’re still buying on dips with short puts as entries (see yesterday’s post), hedging while its cheap, and riding the bull market on the long positions we’ve already got. 


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