It’s Cheap to Hedge Now.  Just Saying…

Yesterday, we made an assertion that protective puts are relatively cheap right now.  Today we intend to prove it.

Specifically, we wrote the following for those who are concerned that the current momentum-driven rally is getting long in the tooth:

One strategy involves a barbell – keep buying the tech-heavy indices but utilizing put options as insurance.  Remember, when we buy insurance, we don’t WANT it to pay off.  And considering that volatility is relatively low right now, the insurance is relatively cheap.

An obvious way to back up that assertion is to point out that the Cboe Volatility Index (VIX) is near multi-year lows, as evidenced by the chart below:

VIX, 10-Years, Monthly Candles

Source: Interactive Brokers

We see that VIX has not been consistently this low since before 2020’s covid crisis.  Remember that even as the virus was spreading around the world, US markets were slow to react.  On February 14^th of that year, when VIX closed at 13.68, we wrote a piece entitled Confessions of a Market Nihilist.  The theme was that traders were so enamored of the Federal Reserve’s expanding balance sheet, triggered by a repo funding crisis the prior autumn, that they were willfully blind to the rising risks around them.  Although we are not facing anything close to that sort of existential crisis – at least not as far as I can see – I do find the agglomeration of important market divergences to be a source of concern.

And heck, VIX is not in the single digits, as it was before the “Volmageddon” of February 2018…

But VIX is a bit of a blunt instrument.  Its calculation utilizes all S&P 500 (SPX) index options with 23 to 37 days to expiration with non-zero bids.  That means that options above AND below the current market are included.  But when we’re hedging downside, only below-market options are relevant.

When we look at SPX skews for options expiring in one and three months over the past four weeks, it does appear that at least some options traders are becoming more concerned with hedging the current advance:

SPX Skews for Options Expiring July 19^th, 2024, Today (dark pink), 2-Weeks Ago (lighter pink), 4-Weeks Ago (lightest pink)

Source: Interactive Brokers

SPX Skews for Options Expiring September 19^th, 2024, Today (dark orange), 2-Weeks Ago (lighter orange), 4-Weeks Ago (lightest orange)

Source: Interactive Brokers

We can see that implied volatilities across the curves have risen in recent days, but the rise is most pronounced in below market options.  Someone has been bidding for puts.

That said, when we look at specific options from a moneyness viewpoint, the rise is relatively minor.  Below are charts for 1-month and 3-month SPX options with constant 95% and 90% moneyness (meaning 5% and 10% below the then-current index level).  We chose those levels because they are reasonable ways to hedge a pullback or a correction.  While they could protect against a sharper decline, these are not “disaster” puts.

Implied Volatility of 95% Moneyness SPX Options Over the Past Year, 1-Month to Expiration (white), 3-Months to Expiration (blue)

Source: Bloomberg

Implied Volatility of 90% Moneyness SPX Options Over the Past Year, 1-Month to Expiration (white), 3-Months to Expiration (blue)

Source: Bloomberg

While these implied volatilities are off their lows, they are still among the lowest levels we’ve seen over the past year.  When we look over a five-year horizon, we see that these are also among the post-covid lows:

Implied Volatility of 95% Moneyness SPX Options Over the Past 5-Years, 1-Month to Expiration (white), 3-Months to Expiration (blue)

Source: Bloomberg

Implied Volatility of 90% Moneyness SPX Options Over the Past 5-Years, 1-Month to Expiration (white), 3-Months to Expiration (blue)

Source: Bloomberg

Hedge the current rally if you’d like.  Or not.  It’s up to you.  But if you do choose to hedge, it’s clearly not a historically expensive time to do so.