Daily Cost of Hedging

by Jay Pestrichelli on November 7th, 2011

Evaluating the cost of hedging is an important part of hedging. In our book Buy and Hedge: The 5 Iron Rules for Investing Over the Long Term, we use the term Cost Percentage as means evaluating the price associated with hedging premium. As the name implies, it’s the amount of money the hedge will cost the investor relative to the underlying asset being protected.

The equation changes slightly depending on weather the hedger is using a married put, portfolio put, collar or even a spread, but the basic premise is the same. We like to use the cost of establishing a portfolio put as the general means of calculating the cost of hedging in a particular market environment.

A portfolio put is defined as a long put purchased by itself to cover a certain dollar amount. Typically, an index representative of the portfolio’s make up is chosen and most default to the SPX (S&P 500 Index) as the tool to do this. The premise being that if a portfolio goes down, so will the broad market and that a hedge on SPX can adequately provide coverage.

What is also true about the SPX is it provides a proxy for the cost of hedging. In other words, if you want to know if buying puts for protection is cheap or expensive, compare it to the cost of buying a portfolio put using the SPX.

For a portfolio put Cost Percentage, the equation uses the dollars protected. Dollar assets are represented as the value of the strike price of the put purchased. Meaning where will the put start to gain intrinsic value as the overall market is going down the other way. Remember, puts go up in value as the market drops.

So for a portfolio put, CP = price of the put / (price of the put + strike price). For example, if an 1100 strike put costs \$45, CP = \$45 / (\$45 + \$1100) = 3.9%.

Options have expirations. This means that they are only good for a certain amount of time. So while knowing the cost is important, its is equally important to know they daily cost if one is to determine if the protection is cheap or expensive in a relative manner. One simple way to do figure this out is just realize the daily rate.

Daily cost can be determined by dividing the CP by days till expiration. If the above portfolio put was going to last for 60 days (i.e. 60 days till expiration), then simply divide 3.9% by 60 to get a daily rate of 0.065% or 6.5 basis points. Basis points are one hundredth of a percentage point. 100 basis points = 1%.

In the chart below, we’ve tracked the cost of some short term and longer term portfolio protection. This protection aims to protect at a level 10% below the current SPX price.

In the chart below, we’ve tracked the cost of some short term and longer term portfolio protection. This protection aims to protect at a level 10% below the current SPX price.

Two observations from this chart:
1-Typically, the short-term protection is more expensive than the longer term protection on a daily basis.
2-The cost of both the longer term and short term protection is inversely correlated to the price of the SPX. This isn’t surprising considering that as people feel the market will drop, the price of insurance will go up.

Right now the price of insurance is cheaper than the volatile days of September and beginning of October. However, relative to the summer months, it is still slightly expensive.

Going forward we will post these data points regularly on our Resource Page and update Twitter with alerts on this as well.

Happy Hedging!

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