Low implied volatility levels with a looming Fed decision and unpausing of government economic data releases leaves markets vulnerable.
Markets have been relatively quiet since the start of the fourth quarter with the S&P 500 Index (SPX) gaining 2.36% so far. Volatility has fallen over the last few weeks to near the lowest levels of the year and while breadth has slowly come back into the market, this is still an environment where a handful of names at the top of the indices has carried them higher, a point we touched on in yesterday’s feature (click here for more). While markets have been consolidating and preparing for their next big move, the Fed makes their interest rate decision Wednesday, December 10th, which could be a strong catalyst in either direction. The markets are pricing in a 25 bps cut, but the FOMC’s statements on the economy will likely carry plenty of weight, especially following a period of sparce economic data during the government shutdown. With some data coming out late and others not coming out at all, it’s a difficult time for investors using that data in models which is why it’s a little surprising to see volatility so low. The CBOE SPX Volatility Index (VIX) is charting at 16 on its one-point chart, just a single box from its low for the year.
With all that said, the technical picture for domestic equities is still strong. However, the pace of gains has slowed down and there are plenty of opportunities for volatility expansion over the next few months with implied volatility already low. Given this backdrop, looking to hedge portfolios with ETF options currently is reasonable. For those that need an outline on how to use ETF options please click here. Instead of focusing on the “how to” let’s focus on figuring out a good hedging strategy, so here are some thoughts on how I would proceed if I were putting on a portfolio hedge today. Going out further in time than what one would to hedge through an earnings season would be preferred. With the pause in economic data, it may be a couple of months before the market makes a move on the data with the expected noise. This also allows for more flexibility if the market declines sooner than expected, one could cover the put position for a profit well before expiry. Also, volatility further out is reasonably priced in the May to July timeframe. The image below shows the VIX futures term structure, notice that it begins to flatten off after March. Therefore, looking at the May to July put contracts gives us a few months before volatility decay starts to really kick in and gives us a chance to sell back our puts if the market doesn’t fall.
Secondly, fully hedging the portfolio with at-the-money puts doesn’t make sense for most people given the higher costs than going out-of-the money. Targeting strikes around 5-10% out-of-the-money makes the most sense depending on what you think clients would be comfortable with paying for insurance. Realistically, a five percent decline is to be expected when invested in equities, we want to protect ourselves against steeper declines in the market while still hedging against more severe market outcomes.
Looking at the five-point chart of the SPDR S&P 500 ETF (SPY), $655 is a big support level and if that breaks there is not much support until $620 with the next level of support at $580. $650 is about 5% below current levels, so we’ll target that strike for our puts. For the expiry, we’ll use the June 18th series which costs about $19.30 per contract and would be about 2.8% of the portfolios value if fully hedging. Fully hedging the portfolio may not be necessary, even just hedging half of the portfolio would help immensely if there was a material drawdown. Remember to only hedge what is appropriate. If the market hasn’t shown signs of weakness by March, then it would be a good time to take look at selling back the puts for a loss rather than letting them expire worthless. There is never a perfect time to pay for insurance, but there are better times to pay for it than others.
