By Derek Moore
Typical Buy and Hedge Classic Construction
We normally purchase shares of SPY to gain exposure to the S&P 500 Index.
It pays a dividend and can be held indefinitely which helps be more tax efficient in taxable accounts. Then we purchase a long put spread that starts the protection about 10% below the market (out-of-the-money). Buying a put 10% down and selling another put about 25% down. Essentially, you’ll feel the first 10% drop but then be hedged from 10% down to 25%.
This build has worked over the years, but of late we’ve noticed that puts, even at-the-money puts, have become much cheaper.
Cheaper Puts Allow a Better Structure
The adjusted structure instead buys a put around the money and sells another one roughly 20% lower.
You have protection from 0% down to -20% down. The cost of hedging annualized is less than 3%, which is very cheap and meets our rules for a hedged position with Buy and Hedge Classic. Give the choice you’d probably like to be hedged at the money instead of starting 10% lower. It also hedges a total risk of about 20% vs 15%.
We just like this structure better for you and your clients in this version.
Why Are Puts So Cheap?
The easy answer is to look at the VIX Index and the VIX Futures across the curve out 12 months.
Volatility is low! When it’s low, the cost of options declines unlike when everyone is piling into protection during a surge in volatility. You could almost say it’s cheap because no one wants it right now. We tend to think you should always be hedged so cheaper protection is a gift.
The other reason is a little more complicated and has to do with interest rates and the cost of carry.
Calls become more expensive relative to puts when the risk-free rate is higher like it is now vs. the decade before. The reason is that the market maker who is taking the other side of a long call trade must buy stock and give up the interest they would have received. That cost is passed along in the price of the call. Interest rates and the size of the dividend (if there is one) both impact the pricing of calls vs puts.
The quick answer is puts are cheaper with higher rates.
The benefit to you and your clients is you wind up with cheaper and better protection!
Feel free to reach out to a member of the ZEGA team to learn more about Buy and Hedge Classic or any of our other strategies.