The High Cost of Hedging

The High Cost of Hedging 

Courtesy of Paul Price 

Americans love insurance. FEMA is paying to rebuild beach houses ruined by Hurricane Sandy. Allstate, State Farm and GEICO will replace the car you accidentally totaled. AFLAC will cover all your bills if you are too badly injured to work. Airlines such as Southwest (LUV) regularly hedge jet fuel prices, and Hershey (HSY) hedges by playing with cocoa futures.

Does it make sense to buy portfolio insurance that will pay off if the market drops 5% – 10%?

Before answering, let’s look at the math. 

How much does it cost to buy stock market correction protection? I’m using the SPY (S&P 500 ETF) as a proxy for broad market action. At about 12:40 PM on Friday, April 12, 2013, the SPY was trading for $158.40 per share. 

Buying out-of-the-money July 20, 2013 expiration puts, at a strike price of $145, costs $1.22 per share. These puts would not retain any value upon expiration date unless the SPY dropped by over $13.40/share (-8.5%), to less than $145. True wealth protection would only kick in if the SPY dropped even more. Including the option premium initially paid, break-even on the puts becomes $143.78 per share, 9.2% below the trade inception price.

The premium paid might not appear steep at 0.8% of the SPY’s trade inception value ($1.22/$158.40). However, the large deductible, combined with only a 98-day duration, makes the price tag quite expensive relative to the limited protection you would get.

Nervous investors seeking ‘lower deductible’ insurance could purchase at-the-money $158 strike puts for that same expiration date. That would require a $4.30 per share initial outlay (2.7% of the current principal amount). Should that be appealing to traders when viewed as term insurance?  

SPY July 2013 Put Prices

You need to keep in mind that your ‘policy’ only lasts for 98 days. A full year’s coverage would be 3.72 times those absolute put premiums. The $145 strike would annualize at 2.86% of portfolio value. The $158 strike costs a staggering 10.1% per year of the SPY shares that would be protected. 

Compare that annual 10.1% put buying outlay to the most recent historical full-year total returns on the S&P 500. The insurance expense would have consumed 63.0% of 2012’s results, 66.9% of the 2010 gains, and 38.1% of 2009’s outstanding profits. Instead of a small positive result in 2011, this strategy would have resulted in an almost 8% loss, due strictly to the cost of hedging. 

S&P 500 Total Return 2009 - 2012 (1) 

Those opting for lower deductible catastrophic put protection also impaired their financial well-being. It is not that the broad market never sold off. There were four major down cycles since the start of 2009. Unless you were prescient enough to call the exact tops and bottoms, the magnitudes of the drops were never large enough to generate significant profits from owning puts. Neither of 2012’s retreats came to even 11%. 

Only the 5-month, close to 22% drop in 2011, offered much opportunity to cash out puts for big gains. The talk at that time was for another 2008-type 50% collapse. Many people who held temporarily valuable options ended up watching their gains evaporate as the indices rebounded into year-end rather than falling further.

SPY 4-years (weekly)  as of Apr. 12, 2013

 

“Buy and hold is dead” is frequently quoted and accepted as fact. We have all been trained that “You never go broke taking a profit.” The 4-year SPY chart proves that ignoring what can often be disturbing news, and hanging in there with your investments, may be the best advice of all. 

The insurance premiums you don’t pay can be invested and compounded via dollar cost averaging rather than weighing down your results when market rise. On balance, you’ll do better by going naked than being insurance poor. 

 

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