Cost of Hedging Weekly Update 12-13-13

by Jay Pestrichelli on December 12th, 2013

As the tenor of the market continues to show some bearish bias, the cost of hedging in the short-term is creeping higher.  As of the Dec 12th the short-term daily cost was 0.89 basis points per day and the mid-term cost out to June 2014 was 1.01 basis points per day.  
 
See data for the past 28 months on our Resources Page
 
Something very interesting is going on in the options market right now. Options trading out a few month are starting to pop in value while the longer term (6-7 months) are holding steady at normal levels. We see this in the price of hedging for the March period compared to what it was just last week for February. We can interpret this as the market anticipating an increase in volatility for March. Remembering that volatility usually coincides with a market decline.
 
What is all the worry about for March? There are 2 events that one should expect to cause some trepidation for March. The first is that most economist project tapering to occur after the March Fed meeting. Second, the next “hard” debt ceiling deadline is projected to be March as well. Here’s an article from CNBC back in October reflecting that date.

It is fair to say that with these two market moving events looming over the bull market, a rise in protection seems warranted. Digging in a little, there are signs the market is in agreement that the spike in volatility is coming as well in the VIX options.
 
As we’ve said in other blog posts, the VIX is the index that reflects the implied volatility of the options on the S&P 500 over the next 30 days. The calculation is complicated, but in a nut shell it is meant to represent how the options market is evaluating volatility. Although the VIX index itself cannot be traded, there are VIX futures, VIX options, and ETF’s based on the VIX. Traders that feel savvy enough can trade these derivatives on the VIX if they want to play volatility. We would caution investors to understand the intricacies of these instruments as they are irregular and have unique relationships to each other that no other asset class has.
 
Even though they are obscure to many, we still watch them and the last three weeks has seen some very interesting trading. There have been 4 very large trades on volatility using the VIX index options made  for the April expiration which is on Wednesday April 16th (139 days). Yes, I said a Wednesday for expiration instead of Friday. There is a reason for that, but that isn’t very important, so I'll spare you the minutia.  These large trades were as follows:
  • 11/26: 53,000 contracts on the APR 24 Call
  • 12/2: 55,000 contracts on the APR 24 Call
  • 12/10:  22,000 contracts on the APR 22 Call
  • 12/12: 40,000 contracts on the APR 22 Call
These 4 trades come to about $18 million dollars worth of option calls and were all much larger than any other trades in any of the expirations before April.
 
The great thing about option data is we have clarity of volume and open interest to see if there is something that stands out, like these trades. The bad thing is we really don’t know the intention of the trader. They may be speculating or betting that the market volatility spikes in the next 4.5 months or they may be placing a hedge to protect a much larger position that is long the market. We really don’t know.
 
Either way, these trades have a combined break even around 24 on the VIX, so they are looking for at least an upward move of 55%. Right now there is only a 13% chance of that happening and the futures are only pricing the VIX to be at 17.6 at April expiration. You can click here to learn more about VIX futures from the CBOE.

Let's bring this deep dive of the VIX options market back to the cost of hedging.  We can assess that the current flow of option money into the March SPX options and the April VIX options is telling  that somre are bracing for impact. These actions and more like them, will push the cost of hedging higher.


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