Cost of Hedging Update 1-21-14

by Jay Pestrichelli on January 21st, 2014

2014 is starting out just the way 2013 ended. The cost of hedging is low low low and the market is pressing up against new highs on a regular basis.   As of the Jan 17th the short-term daily cost was 0.67 basis points per day and the mid-term cost out to September 2014 was 0.79 basis points per day.  
See data for the past 29months on our Resources Page
It has been a few weeks since we’ve updated you on this topic, mostly because the story has been the same. However there is one notable point to make. Just after Christmas on January 27th, we hit a new 2 1/2 year low in the cost of hedging.
The most notable was the mid-term cost that dropped to 0.79 basis points per day with 174 days till expiration. The strikes to calculate this were about 10% below the market and you could have hedged your portfolio through September’s expiration for only 1.37%.
So what are we doing with these low rates, you may ask? The answer is taking advantage of it whenever we can. Most of the hedges that expired at the end of the year got a great new low cost of hedging at higher market levels. However the bigger news is that we think there is affordability to tightening up your hedges by using calls spreads in replacement of long stock protected by a put.
For example, say you wanted to put $200k to work in the market today. Buying an SPX (S&P 500) Call for the Jan15 expiration at a strike of 1825 will cost about $10,500. This position has a notional value of $184,000 and is has a max loss of what you paid for the call. We consider this position to have a 5.7% cost of hedging and is the break-even of where the market has to rise to offset it.

Now sell a 2000 strike call (about 10% above market) for $3,000 and you’re net out of pocket is reduced to $7,500.  What you’ve created is a synthetic version of being long $184,000 by only spending $7,500. The max loss is $7,500 and the max gain is growth to the 2000 strike call. That works out to be $10,000 (100*(2000-1825)-7,500).  Or said another way, -4% to +5.5% portfolio range for the year. This is probably narrower of a range than most want, but it shows how you can create a downside limit to your risk and still leave plenty of room to grow.  If you are willing to take a larger loss, these numbers become even more advantageous.

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