BofA interest rate strategists Ralph Axel and Ruslan Bikbov suggest that now would be a good time to buy tail risk hedges. (hat tip Joe Weisenthal) 6-month options on 10-year swap futures are as inexpensive now, they claim, as they’ve been in decades, excluding one period in 2006.
6M IV on 10Y Swap Futures, bp. Source: BofA Merrill Lynch Global Research
So far, so good. If rates are your key concern, this looks like a decent time to add tail risk protection. For corroboration, note that the cost of 1-month options on Treasury bonds (yellow line) is almost as low now as at any time since 2008, even while the historical volatility of the futures trades at a higher rate.
1M IV on Treasury Bond Futures. Source: iVolatility
Then Axel and Bikbov cite low levels in the spot VIX index as a further justification for putting on tail risk hedges:
The VIX, a measure of implied volatility of the S&P 500, is also near historical lows. At 15.8 (as of Wednesday afternoon) it is a point above its low of 14.6 going back to the beginning of 2008. The VIX fell to these levels 3 times since the beginning of 2008: in August (before the crisis of September 2008), in April 2010 (before the first euro sovereign crisis), and in May 2011 (before the US debt limit crisis and second euro crisis; see chart). We do not mean to imply that the VIX is signaling a crisis, but we do mean to point out that options are cheap. And history tells us that if one is interested in hedging tail risks, the best time to buy is not in the midst of a crisis or a strong recovery, but at times like now when the market is lulled into a belief that the future holds neither large upside nor large downside shocks.
Where actual trades are concerned, the rule of thumb I work with is that changes or levels in the spot VIX alone never provide sufficient justification to do anything. In this case, the actual cost of hedging equity exposure is much higher than a chart of the spot VIX would suggest.
First, the term structure of SPX implied volatility is relatively steep, no matter which estimate of volatility you consider. The attached chart shows volatility levels implied by at the money SPX options, VIX-style estimates of SPX IV, and VIX futures, with a historical GARCH estimate included for good measure.
2012 S&P 500 Volatility Forecast. Source: Condor Options
While you can buy a one-month SPX put or straddle today and pay 14-15% annualized IV, you won’t see prices like that further out in time. Taking BofA’s 6-month horizon as a guide, September SPX options at the money are priced around 18%. Since we’re talking about tail risk hedges, i.e. assuming you want to hedge the tails of the distribution, buying strikes that are >10% OTM will cost 23% or more. The VIX-style SPX IV curve above illustrates just how expensive it still is to buy hedges via options. (I review a version of this chart expanded out through 2013 and discuss the data in my March column for Expiring Monthly.)
Second, look at current option prices in relation to the actual, historical volatility of the underlying asset being hedged. Since 2000, the average one-month historical volatility of the S&P 500 has been more than 18%. Current SPX 1M HV is more like 11%. So options markets are already anticipating an increase in volatility in the direction of the historical mean. More importantly, when the market is moving at an 11% clip and the protection you’re buying costs 23% or more, that looks like very expensive insurance. You probably wouldn’t take out a multi-million dollar life insurance policy on a healthy 23-year-old; given how healthy this market has been acting of late, there’s no reason yet to pay still-high prices for put options.
1M SPX Historical Volatility, 2000 – 2012. Source: Condor Options
Finally, historical context does not suggest that options are especially cheap, or that VIX is abnormally low. In a sustained bull market, volatility can get much lower than this. VIX spent nearly all of 2003 – 2007 below the 20% threshold, and made a low of 9.39 in late 2006. SPX 1M HV was similarly muted over that period, trading under 6% annualized at one point. To pervert the classic Keynesian dictum, the VIX can stay low longer than your hedging account can stay solvent.
After looking at SPX hedging costs and the high volatility risk premium in option prices after the 2008 crash, I came to the conclusion that the most cost-effective way to hedge an equity portfolio isn’t to buy puts, but to allocate capital dynamically to VIX-based futures and ETPs. Allocating hedging capital gradually as it is needed allows you to keep costs down in environments like this one. There’s a good qualitative point that Axel and Bikbov make: that as conversations turn toward economic recovery and as everyone (rightly) lauds central banks for having pulled us back from the edge of several disasters, fewer managers are inclined to protect themselves against ever-present tail risks. That’s a fair assessment, but I think the proper response in light of high option costs is to look for nimbler approaches to hedging.
Disclosure: we publish and manage client accounts following a tail risk hedging strategy that allocates capital to VIX futures dynamically as needed.