The Federal Reserve lowered the cost of hedging your equity portfolio. I’ll explain here and provide some examples of smart options hedges to put on from here. The Fed reiterated a forecast for three rate cuts this year while signaling that they may tolerate inflation rates above their stated 2% target for a longer period. They did this when Fed Chief Jerome Powell indicated that the central bank could cut rates before the inflation rate hits that 2% target first, if policymakers believe inflation is trending in the right direction. .SPX 5D mountain S & P 500, 5 days While inflation hawks will likely point out that the risks of cutting rates early are significant — Fed missteps in the 1970s demonstrate that failing to put out the fire of inflation completely may result in a conflagration much more damaging over time — equity markets understandably rallied on this news. As is generally the case because the S & P 500 and the CBOE Volatility Index (the ‘VIX’) are anticorrelated, as the market rallied, the VIX — a measure of 30-day “implied volatility” which one may also think of as the price of 30-day S & P 500 options — fell. .VIX 5D mountain CBOE Volatility Index, 5 days As I write this, the VIX Index is now roughly 12.8. To put that in perspective, the average level, calculated from historical options prices dating back to January of 1990, is 19.5 and the median is 17.7. Another way to think about that level is that it is the 16th percentile historically. That is, 84% of the time over the past 33 years, 30-day SPX options prices have been higher than they are right now. The trade When implied volatility falls the price of an option falls. In the case of SPDR S & P 500 ETF Trust (SPY) options for example, the implied volatility of the April 30th expiration $500 strike puts, as measured by implied volatility, fell from nearly 13.9% before the Fed announcement, to about 13.5% following. SPY YTD mountain SPDR S & P 500 ETF Trust This may not seem like a huge drop — about 3% in the price of the option all else equal — but of course the S & P also rallied sharply at the same time. Accounting for the shift in both, the price of that option fell from $2.80 before the announcement, or 0.54% of the price of the underlying, to $1.80 immediately after the announcement, or 0.35% of the price of the underlying. Considering SPY closed 2023 at $475 that’s pretty cheap insurance to protect a portion of the gains we’ve seen so far this year. A SPY position hedged in this way would look like this : Buy 100 SPY Buy 1 April 30 $500 Put If I want insurance for a longer term, then the January 2025 $500 strike puts are just over $15 right now, less than 3% of the price of the underlying. The trade here : Buy 100 SPY Buy 1 Jan 17, 2025 $500 put Again, as SPY closed 2023 $475, purchasing those puts would lock in a portion of this year’s gains while continuing to allow upside participation if the market rally continues for a cost of less than 3%. DISCLOSURES: (None) THE ABOVE CONTENT IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY . THIS CONTENT IS PROVIDED FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSITUTE FINANCIAL, INVESTMENT, TAX OR LEGAL ADVICE OR A RECOMMENDATION TO BUY ANY SECURITY OR OTHER FINANCIAL ASSET. THE CONTENT IS GENERAL IN NATURE AND DOES NOT REFLECT ANY INDIVIDUAL’S UNIQUE PERSONAL CIRCUMSTANCES. THE ABOVE CONTENT MIGHT NOT BE SUITABLE FOR YOUR PARTICULAR CIRCUMSTANCES. BEFORE MAKING ANY FINANCIAL DECISIONS, YOU SHOULD STRONGLY CONSIDER SEEKING ADVICE FROM YOUR OWN FINANCIAL OR INVESTMENT ADVISOR. Click here for the full disclaimer.
