Cost of Hedging Weekly Update 2-10-14

Posted on February 10th, 2014

If you went on a 5 day vacation last week and just got back you may think you didn’t miss anything interesting in the market. However we all know the exact opposite is true. As of the Jan 27th the short-term daily cost dropped to 0.76 basis points per day and the mid-term cost out to September 2014 was virtually unchanged at 1.10 basis points per day.  
See data for the past 32 months on our Resources Page

A few interesting things have happened in the cost of hedging. The peak to trough to peak range of the S&P 500 was 2.5%.  Monday saw the worst trading day since June 20th 2013 with a decline of 2.3%. This sent the VIX to close at the end of day high of 21.44, a level not seen since Dec 28th 2012. You may remember that day as the fiscal cliff deadline miss.
It’s not surprising that we saw short-term costs of hedging spike above the long-term. This is known as backwardation. That means that short-term volatility is higher than long-term volatility. Historically speaking, short-term pops in volatility will create this backwardation and is why we watch for it in the cost of hedging. It also gives market timers a data point to use to detect reversals. In our historical data, you can see that this happened in October and June 2013, although both times it was too short lived to mean anything for the rest of the year. However, in May and June of 2012, it did mean markets were choppy enough to cause some level of fear.  One difference being that the VIX was closer to 25 than the 21 we just experienced.  
Using backwardation as a guide of when to hedge and not can also be helpful. Hedging when the short-term cost is more than the long-term usually is more expensive than it has to be. In the last 2 years when there was some backwardation, a week or two later, the data reverted to normal within a week or so and hedging got cheaper again. For example, this time around on Monday the 3rd, the short term rate popped to 1.32 bps/day while the long-term was at 1.24 bps/day. Fast forward to now and both have declined to more affordable rates.
Choosing when to hedge doesn’t have to be a mystery though. Just keep a disciplined habit of entering when there are no hedging red flags, like backwardation, and you’ll find that you’ve eliminated some of the complication. Think of hedging as something you do unless there is an issue. Compared to trying to time the hedges based on when you think a pullback is coming. If you do this, you’ll stay hedged most of the time and not worry if you’re putting too much drag on a portfolio.

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