Downside protection costs are at a 15-year low, Bank of America says. Here's how to hedge - CNBC

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The cost of hedging against a potential stock market downturn has hit a 15-year low, according to research from Bank of America. When the cost of hedging a portfolio falls, investors are able to protect themselves from a sudden pullback in the stock market at a cheaper price. The Wall Street bank said that the unusual alignment of high-interest rates and low implied volatility is driving the cost of long-dated S & P 500 hedges to lows not seen since 2008. Implied volatility is a metric that measures the market view of future changes in stock prices. Investors can hedge against a decline in the stock market through various strategies. One such technique involves buying put options, which go up in value when the price of an underlying asset falls. On the other end of the spectrum, a call option's value typically rises when the S & P 500 goes up. .SPX 1Y line "The all-time low cost of protection is striking in an environment of 3-4% inflation, a real threat of recession, extreme macro volatility, and high S & P valuations despite high interest rates and a shaky Fed put," said analysts led by Benjamin Bowler, Bank of America's head of global equity derivatives research. "As a result, we find it sensible to buy longer-dated S & P put and put spreads for a lower price than even in 2017, a year that broke several historical records for equity market complacency (including the lowest VIX in history)." Bank of America said that the cost of downside protection had fallen to a 15-year low, reaching 3.3% of a portfolio. The bank estimated that, if interest rates had remained near zero or volatility had risen, the cost of these contracts would sit between 5.1% to 6.7%, respectively. How to buy downside protection? Bank of America recommended selling a 12-month 110% call option and buying a 12-month 90% put option on the S & P 500 index for a $7.62 credit, in a note to clients on Aug. 1. One part of this trade involves selling a call option that will profit, if the S & P 500 falls by 10% in 12 months. This is topped up with buying a put option that will make gains if the S & P 500 drops by 10% over the same period. The Global X S & P 500 Tail Risk ETF provides a potential alternative for those wanting to avoid trading options. This ETF offers exposure to the S & P 500 index, while using protective puts to mitigate significant sell-offs of more than about 10%. Why are hedging costs falling? The fall in hedging costs can be attributed to several factors, according to Bank of America. The high-interest rates, for instance, have enabled investors to go 'short' by selling an index of stocks, reinvesting the proceeds in an interest-bearing bank account or money market fund, and paying dividends to the stock lender. The interest received from the reinvested cash "must bring down the price of the put," the Wall Street bank's analysts said. According to BofA, lower company dividends because of economic headwinds have also forced down the price of the protective options. Typically, when a company issues a dividend, the total cost of the put contract rises.

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Downside protection costs are at a 15-year low, Bank of America says. Here's how to hedge - CNBC
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Downside protection costs are at a 15-year low, Bank of America says. Here's how to hedge - CNBC

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