A few weeks back we explored option prices relative to stocks, in order to pick up a mini portfolio of out of the money put options as hedges against a market drop. That was back when the Volatility Index (VIX) was near 17.
Now market fears have sent the VIX up towards 27, stocks have fallen, and these hedges have gotten substantially more expensive, but they aren’t necessarily ridiculous. The VIX can rise much further and it’s not inconceivable that the market pullback could continue given how far stocks have risen over the last year.
For example, puts for Brazilian iron ore producer Vale essentially doubled in price, yet the stock remains above its early February levels. For $2.65 one can lock-in all the gains up to February 2010, which is far more than just a few weeks back when the same hedge cost just $1.16. Perhaps paying $2.65 is worthwhile given that you’d essentially be locking-in a huge VALE run from $16 – $22.35.
Financial crisis pariahs have also seen their options spike substantially, GE and AIG are two examples. We own both as tiny speculative positions, thus don’t feel the need to hedge here. GE and AIG could go to zero and we’re fine, but for those with large core positions perhaps it might be worth looking at GE or AIG puts.
Given that AIG is near $38 right now, the price of the $12.50 Jan 2011 put implies to us that a lot of people still think the stock could collapse all the way back down towards zero.
Obviously, hedges are also exploding for the entire market right now, but here things don’t look appealing to us now. We’re not so sure we’d want to pay the following prices for S&P 500 protection anymore. Hedging at $105 for this S&P 500 ETF costs $5.30, thus breaks even at about $99.70. Given the SPDR ETF is at about $117, this $5.30 hedge (which costs 4.5% of your ETF value) only starts to break after about a 15% market drop this year.
All in all, hedging stocks has gotten a lot more expensive in a short period of time and now it’s a mixed bag. It might be time to start looking at the other side of the trade, ie. selling deep out of the money puts (for stocks whose long-term story you like) that have jumped in value due to hedging demand.
Note: The author owns shares of AIG and GE. Investors the author speaks to or works with could own securities related to anything mentioned here.