Downside protection costs are at a 15-year low. Here’s how to hedge
The cost of hedging against a potential stock market downturn has hit a 15-year low. The unusual alignment of high-interest rates and low implied volatility has driven the cost of long-dated S & P 500 hedges to lows not seen since 2008, according to research from Bank of America. Implied volatility is a metric that measures the market view of future changes in stock prices. Investors can hedge against a decline in the stock market through various strategies. One technique involves buying “put” options, which go up in value when the price of an underlying asset falls. Investors can also sell — or short — a call option, which typically rises when the underlying asset’s value goes up. .SPX 1Y line “The all-time low cost of protection is striking in an environment of 3-4% inflation, a real threat of recession, extreme macro volatility, and high S & P valuations despite high interest rates and a shaky Fed put,” said analysts led by Benjamin Bowler, Bank of America’s head of global equity derivatives research. “As a result, we find it sensible to buy longer-dated S & P put and put spreads for a lower price than even in 2017, a year that broke several historical records for equity market complacency.” Bank of America said that the cost of downside protection had fallen to a 15-year low, reaching 3.3% of a portfolio. The bank estimated that, if interest rates had remained near zero or volatility had risen, the cost of these contracts would sit between 5.1% to 6.7%, respectively. How to buy downside protection? Bank of America recommended selling a 12-month 110% call option and buying a 12-month 90% put option on the S & P 500 index for a $7.62 credit, in a note to clients on Aug. 1. One part of this trade involves selling a call option that will profit if the S & P 500 falls by 10% in 12 months. This is topped up with buying a put option that will make gains if the S & P 500 drops by 10% over the same period. The Global X S & P 500 Tail Risk ETF provides a potential alternative for those wanting to avoid trading options. This ETF offers exposure to the S & P 500 index while using put options to mitigate significant sell-offs of more than about 10%. “Investors in our ETF, XTR, can indeed benefit from the cheaper cost of options,” said Rohan Reddy, Director of Research at Global X. “Given that the cost of the put options are cheaper, risk management for equities becomes less of a burden to total returns as well.” Why are hedging costs falling? The fall in hedging costs can be attributed to several factors. Investors are choosing to increase their cash positions to manage volatility this year thanks to a rise in the Federal Reserve’s base rate, according to Reddy. This has led “to reduced demand for puts and subsequent price reductions,” he added. The high-interest rates, for instance, have also enabled investors to go ‘short’ by selling an index of stocks, reinvesting the proceeds in an interest-bearing bank account or money market fund, and paying dividends to the stock lender, according to Bank of America. The interest received from the reinvested cash “must bring down the price of the put,” the Wall Street bank’s analysts said. Lower company dividends because of economic headwinds have also forced down the price of the protective options, the Wall Street bank’s analysts added. Typically, when a company issues a dividend, the total cost of the put contract rises.
