Cheapest Protective Hedges Ever on the S&P 500 Index?
By Derek Moore
Stock Market Insurance on Sale But No One Wants It (But You Should!)
Bloomberg highlighted some Bank of America research recently showing that hedging was the “cheapest you’ve ever seen”.
Source: Bloomberg.com
If we look at the graph above, you’ll notice that the line highlighted in the red box is at the lowest point going back to 2008. What they are referring to with the 95% 1-year put is an option that is 5% out of the money below the current price of the S&P 500 Index (SPX) expiring in 1-year. The cheapness is how much the premium on those options costs relative to other periods.
All the while calls are more expensive today than puts due in large part to changes in interest rates.
Markets Making 52-Week Highs with Lower Volatility
It’s human nature that as markets are surging higher, people are more ok with risk.
Investors tend to throw caution to the wind when markets are good but suddenly rush to buy protection during downturns (or go to cash). As volatility comes down, so do option premiums. Implied volatility is a major component of the value of an option.
We’ve used the analogy before about living on the Florida coast and waiting until a category 5 hurricane is off the coast before calling up an insurance company to inquire about getting some.
Oh, now you want insurance?
Downside market protection may be cheaper when no one wants it.
Dynamics of Why Put Options Became Cheaper with Higher Interest Rates
So, there are two ways I can do this, keep it high level or throw a bunch of option math at you.
Let’s try to split the difference. Generally, when interest rates go up it increases call premiums and lowers put premiums. Dividends also factor in where they generally would increase put prices but decrease call prices.
If you were to buy 100 shares of XYZ at $160, you’d spend $16,000.
When you spend that $16,000, you are forgoing what you could have earned in a risk-free treasury bill, currently an annualized rate of about 5.5%. Someone selling those shares and going to cash would collect the 5.5% rate.
Let’s assume XYZ doesn’t pay a dividend to keep things a little simpler. That 5.5% on $16,000 would work out to be $880 a year. That is your cost of carry, but what does that mean for the premium of your call option?
A back of the envelope way to calculate how much cost of carry is embedded in a call option (and not in a put option) can be calculated by the following:
Cost of Carry = (strike price * risk free rate) * (Days to Expiration / Calendar Days in a Year)
Stock = XYZ (totally made-up symbol!)
Strike Price = 160
Risk Free Rate = 5.5%
Days to Exp = 326
Calendar Days = 365
(160 * .055) * (326/365) becomes 8.8 * .8932 = $7.86
It’s worth noting that the BofA analysis only went back to 2008 and most of you probably remember rates have been super low since then.
Just know that higher rates and lower volatility equal cheaper put protection!
Why You Should Be Hedged All the Time
How much time do we have?
We know that timing markets is a futile exercise. Emotion also can make long-term investing stressful. Buying but Hedging helps take out the need to get entries and exits perfect. Protection tends to be cheapest when no one thinks they need it.
When markets are falling apart, the cost of hedging tends to rise.
But when puts are cheaper, it reduces your cost of hedging.
More On Cheaper Market Protection in our Podcast
On the recent podcast episode, I went through in more depth the high points of the Bank of America and Bloomberg pieces on protection being on sale.
You can listen here:
Or on your favorite podcast apps like:
Key Points
- When volatility is low option premiums are lower.
- Option prices have an interest rate component or cost of carry.
- Interest rates going higher increases call prices and reduces put prices.
- Between markets at 52-week highs, lower volatility, and higher rates puts are cheaper.
- Option pricing includes Interest rates, volatility, underlying price, time to expire, and dividends.
- Hedging when it is cheaper can potentially increase your upside participation in markets.
- Don’t wait until markets are falling to put on protection.