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No Reason to Hedge Stocks Yet

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This complimentary article from Options Profits was originally published on September 27 at 8:25am ET.

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Despite the decline in the S&P 500 this week, here are some reasons I'm not putting on new bearish or hedging positions.

1. This is barely a pullback. SPDR S&P 500 (SPY) is down 1.76% from last Friday's close, and is just 3% from its highs for the year, which are also the highest levels since 2007. Weak hands dumping stocks this week are feeble indeed.

2. Quantitative hedging signals lean bullish, too: our VIX portfolio hedging strategy has spent most of 2012 trading with a very light touch, and is currently at its smallest allocation allowed - not for the year, but period.

fig. 1. S&P 500 3M Implied Volatility Skew
Source: Condor Options


3. S&P 500 implied volatility skew is just coming off its lowest levels since 2011. We published the attached chart to clients last week, showing that SPX skew at a three-month horizon was lower than at any time since the spring of last year. While that's not a tradable short signal by itself, the lack of investor interest in hedges and unwillingness to sell upside call options often coincides with short-term market tops and pauses. The price action this week is consistent with that sentiment, and as a result IV skew has rebounded this week toward more normal levels.

4. Actual price volatility is still low, and options still look overpriced. Here are some statistics about the state of S&P 500 volatility:

1-month close-to-close historical volatility: 11.35%

1-month GARCH volatility forecast: 12.08%

1-month at the money implied volatility: 13.91%

1-month strike-weighted implied volatility (VIX): 16.81%

The market isn't just quieter than what options have been implying - it's actually lower than what a statistical forecast would suggest, and has been for some time. Of course, there are always risks, and bearish scenarios deserve attention. But so far, there's no evidence that hedging or bearish exposure is called for.

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