Concern over global growth, the "sequester," rising European bond yields, low consumer confidence, among other issues have caused the price of S&P500 Index options to increase by 19% on Wednesday as measured by the volatility index (VIX).
For those thinking to "sell in May" or already seeing potential macro-risk, there is practicality in purchasing put options on (NYSEARCA:SPY) or being long the (VIX). We will discuss specifics later in the article and will start with a macro perspective, then analyze the price of insurance (VIX) to justify its relative value, and finally its functionality in hedging the S&P500 or other indices.
The "great" recession was deep and the U.S. has failed to experience the robust growth seen in the early 1980's recovery.
The following graphs compare quarterly changes in GDP using data from the Federal Reserve Bank of St. Louis and have been formatted to have identical axis' for comparative purposes.
What do these charts indicate? During the 80's, there were nine periods of 1% growth, and three of those nine were greater than 2%. In the recent great recession, the U.S. had only two quarters reaching 1% GDP growth. The point is that the U.S. is recovering from a deep financial disaster and the recovery has not been as robust as in the early '80s.
How can this be interpreted for someone looking to insure their portfolio? This important question is easily guided by the following probability density function of the VIXs closing values.
The red line denotes our current level of the VIX and the relative frequency since 1990. This is valuable information for any portfolio manager or trader to bear in mind when breaking to record highs in the equity markets. Clearly we are placed in the first quartile of the distribution, so relative to an average day, insuring your portfolio is cheap. Also consider that I have used data starting in 1990. If the same graphic was built based on the past 5 years of data, we would be in the lowest 2% of the density function as seen below.
Options on the S&P 500 (SPX) are implying less than 14% volatility for the next 30 days, 15% the next 60, and 16% until the month of May. Those who followed yesterdays VIX article likely made a generous return selling VIX puts, but should you take your profits? Or should you buckle down for potential volatility? If you believe that history repeats itself and that the VIX is mean-reverting, then yes, you should position yourself accordingly.
The best way to hedge in the near term is not to purchase contracts that expire in 60 days (because of theta decay). If you want to use near-dated contracts I would stay on the sell side of puts. I would strongly encourage individuals with cash to insure their portfolios using a bit of margin. For example, here is a costless trade that can protect your account for the next few months.
Sell 1 X SPX Sep 2013 1450 Put @ $50
Buy 2 X SPX Sep 2013 1325 Puts @ -$25
Total Cost (Ignoring Margin) $0
This position has a tremendous payoff and costs approximately $10 per day to hold. A 1% increase in implied volatility will benefit this position by $167. Another way to think about this trade on a 60 day horizon would be to say, "If implied volatility jumps by 4%, which would likely be triggered by negative news, then this position will profit more than the 60 day depreciation, meanwhile it benefits from exponential growth if the markets slip."
There are many ways that one can decide to hedge, play index options directly, or trade them through the (VIX), (NYSEARCA:VXX), or (NASDAQ:TVIX). The point is that despite our 19% pop in the VIX Wednesday, insurance is still cheap, so if you think there is going to be a pullback, strategize accordingly.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.