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What We Can Learn From the Cost of Hedging


As a proxy, look at what it costs to purchase puts 10% below the S&P for short and long-term intervals.

One of the things we track at my firm Buy and Hedge very closely is the cost of hedging. As a proxy we look at what it costs to purchase puts 10% below the S&P for short and long-term interval. This level isn't necessarily anything special except it seems to be the midpoint of what most investors are willing to endure at any given time.

We track the cost of these puts as the daily cost for the protection they provide. Using the same calculations for portfolio put hedges from our book, we are able to determine the daily cost of the puts. This is typically a very small number on a percentage basis, but it allows us to create consistency regardless of expiration as well as account for the amount of protection the puts provide. Below is the data back to July 2011.

The calculations for this data are as follows:

The SPX closed on May 14 at 1338. Ten percent below the market would be 1204. Since there are no strikes at 1204, we look at the nearest one, which is 1200. The 1200 put protects $120,000 (100 x 1200) worth of assets. The December monthly puts, as of the close on May 14, had 220 days until expiration and were trading around $49.

Based on this information, a hedger could protect $120,000 of assets for 220 days at a cost of $4,900. That is about a 4% cost for 220 days, which means the daily rate is 0.018% or 1.8 bps.

The daily rate is what we track. This allows us to compare the cost regardless of days till expiration and a moving market. (Click here for more detailed view of the data.)

Now that we've got that explained, here's the interesting part. Typically, options over a longer period of time have a lower per-day cost. This is because time decays slower on long options the farther out the expiration. It's one of the widely accepted truisms of option pricing. However, since mid December of 2011, the reverse has been the case. The daily cost for the long- or mid-term options has been more expensive than the short-term options.

This has led us to believe that the options market was giving a lower probability to a pullback in the short-term than it was in the long-term. In other words, when the option pricing was inverted, short-term protection was cheap and long-term was less cheap (they were both cheap especially around late February).

Looking from the other side, during the market volatility of August through September, the short-term protection was more expensive than the long-term protection. Much of this is based on probability projections worked into the options pricing, and for those enthusiasts out there, you'll notice that the price of options is highly correlated to volatility. The more volatile, the more likely a 10% correction will occur by expiration.

Yesterday, May 14, was only the second time that pricing reverted to the norm this year when the long-term puts had a lower per-day cost than the short-term puts. The first time was on March 6 after the SPX was down almost 20 points and volatility looked to be returning. But it only lasted for one day and the environment slipped back to inversion.

The market is telling us that the chance of a pullback of 10% in the near term is getting closer to the likelihood of one in the long term. As we continue to watch and track this trend, we can use it as another data point when forming our investing thesis and watch this as another way to measure fear in the markets.

Editor's Note: For more from Jay Pestrichelli, go to Buy & Hedge ETF Strategies.
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