Cost of Hedging Weekly Update 12-6-13

Posted on December 6th, 2013

After the first four days of December started out negative, Friday’s pop on the jobs data helped the cost of hedging retrace to historical lows.  As of the Dec 6th the short-term daily cost was 0.64 basis points per day and the mid-term cost out to June 2014 was 0.90 basis points per day.  
See data for the past 28 months on our Resources Page

Friday’s 1% rise in equities came after 4 days of the bears asserting their will this week. The drop in the unemployment rate to 7% (the lowest since Nov 2008) has investors believing that there truly is a recovery going on. There was also a rise in the participation rate, but it has yet to be seen if that will hold through the holiday season.

Here is a chart from with the historical payroll numbers:
This rise in the market dropped the cost of hedging once again and we’re back to where we were at the end of last week. This historically low rate is one that continues to make hedging a good choice while the market is so high. Locking in the gains of 2013 in this December is a good way to avoid any choppiness we may see in January.

Recently a client asked about raising existing hedge levels, so I thought I would bring that conversation to the fore-front. If your hedges are running out now or in January, you’ve most likely taken all the losses you’re going to get in them. Add to that they are probably at levels that are so far out-of-the-money that they aren’t protecting very much. If that is your situation, go ahead a close them out and rebuild a little early. Taking the loss now in December of 2013 is a good way to offset some of the gains you may have racked up in the rest of your portfolio.
Where you decide to buy your new protection is up to you, but out a year to December 2014 will run you somewhere around 4.5% for a 5% downside hedge, 3.6% for a 10% downside hedge, or 2.4% for a 15% downside move. If you’re of the belief that there are no significant events to shake this rally, go with the cheap protection at 10% or 15% and keep those costs low. If you’re worried the rally is over, the 5% hedge will benefit you more if your fears are realized.
However, if your existing protection goes out farther than then next 2 months, tightening up the hedges may not make sense. Again, you’ve probably experienced 66% to 75% of the loss on the hedge so far and locking in that loss 4 or 6 months early will have you hedging the same assets twice and at a net greater cost. However, it can make sense if you’re overly bearish at this point. As it turns out if the market was to sell off 20% between now and June, the tightening of the hedges would make a positive difference. Any decline less than that, and it seems your wasting money and being too handsy on the hedges.
If your belief is that in 6 months this market has a good chance of being 20% lower, we’d recommend a rotation out of a long strategy in the first place. Perhaps a closure of half the long exposure and rotation into some bearish put spreads on the weakest sectors would be a better bet than spending the money on tighter hedges.
Either way, unless your hedges are expiring, a rotation to tighter hedges just doesn’t seem like the play right now.

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