Now Is The Time to Hedge, But The Cost of Insurance Can Be Expensive

At the beginning of the year, as the markets reached new highs, investors became more complacent. Early this month, Rupert Hargreaves noted:

Investors have plowed billions into stocks over the past few months while the generally positive sentiment within markets has helped pull central banks back into the shadows. Central bank decisions no longer have such an impact on equities. Of course, as the market has rallied to new highs there have been renewed calls that equities are in a bubble. Indeed, as we note further below investors have ceased to hedge. Read more

However, the last couple of weeks has witnessed an increased uneasiness beneath the surface, as shown by the SKEW index.

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CBOE SKEW index as at March 10, 2017. Source: Barcharts.com

In the article entitled, The quest for low-cost hedges against a future crash, John Dizard pointed out that the SKEW index is not an accurate timing indicator. This is in agreement with our conclusion. We developed and tested a timing system based on the SKEW index. It is profitable, but the Sharpe ratio is lower compared to other systems. Our research results were published in this post.

However, he also pointed out that SKEW is a good proxy for the cost of insurance and right now it appears to be expensive:

Skew can range from close to 100 to a bit over 150. At the moment it is around 140, up from 125 in January, and at the high end of its range since the contract was introduced in 2011. That means the investors buying futures, as a group, are apparently willing to pay over the mathematical odds for protection against a market decline. Read more

Instead of buying expensive puts, investors can hedge against a market correction by investing in long-convexity funds. These funds utilize a trading approach that is called tail risk hedging:

Tail risk hedging strategies aim to protect against extreme market moves. The idea is to give up a little bit of return each year to purchase protection against a market meltdown. The focus is on identifying the key aggregate balance sheet risk factors and determining the cheapest way to protect against these risks. So tail risk hedging is a bespoke strategy.

In summary, it’s necessary for investors to hedge, especially during the times like this. However, the cost of hedging can be expensive, and many investors are not willing to pay for the costly insurance. In the next article we will go into more details about tail risk hedging. This might provide a solution for investors who are looking for a cheaper hedge.