Hedge Check Into the end of the Year

Yesterday's broad market pullback was noteworthy as one of the top 15 moves this year for both the S&P 500 (SPX) and CBOE VIX Indexes (VIX). With SPX up nearly 25% this year, many investors are looking at returns that are well above what they expected given the tail end of Fed stimulus and pace of the US economic recovery. Many portfolio managers are looking at a year of double-digit percent gains and looking at ways to hedge those gains, trading a percent or two for the peace of mind that comes with knowing your downside is relatively limited.

While there are dozens of ways to implement a hedge- the simplest and most common today are SPX puts and VIX calls- both tend to spike in value in times of crisis- which is the entire point of the hedge.

As the market crunched higher over recent months and implied volatility slid to the 12 handle this fall, some option traders began to wonder how 'hedged' the broad market was- with the supposition being that a hedged market is a healthy sign since managers are less likely to dump stocks into a decline if they are hedged.

Yesterday's slide did not have that feeling of panic but still had the power to spook some traders who may have already spent their expected Christmas bonus, so it's interesting to estimate the inventory of hedges in place to anticipate what kind of option flow a further decline might spur.

One quick way to gauge hedge levels is simple open interest- SPX OI is currently over 15.1 million contracts, which is in the top 2% of this years' daily levels. Total put OI is over 9.3million contracts- in the top 15% of the range- suggesting a relatively robust level of hedges. On the VIX side we want to focus on calls since those are relatively similar to SPX puts in terms of payoff. Total VIX OI is 8.3million with calls making up 67% of that. VIX call OI is near the top 25% of it's 52wk range, which is a moderately strong indication of hedges in place.

In my view, the combination of SPX puts and VIX calls open today indicates a moderately high level of hedging into year end, which should help avoid an ugly spiral downward if the broad market continues to slip lower.

OptionsProfits can be followed on Twitter at twitter.com/OptionsProfits

Henry can be followed on Twitter at twitter.com/OptionAlert

At the time of publication, Henry Schwartz held no positions in the stocks or issues mentioned.

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