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The Cost of Being A Bear Is Soaring: Demand Or Supply?

If, like us, you believe the colossal US equity rally off the 2009 lows is entirely out of sync with economic reality and is now primarily driven by easy money and corporate buybacks, it will cost you a pretty penny to hedge the madness in the options market. As Bloomberg reports, buying long puts to bet that gravity (i.e. reality) will one day reassert itself — and finally burn the last ones to buy into the greater fool theory of investing — is now far more expensive than buying calls to gamble on further upside. What’s to blame for the high cost of downside protection? Some blame a stricter regulatory regime and some suggest something far simpler: the chances of a “correction” are going up with each passing day. 

Here’s more:

Prices for Standard & Poor’s 500 Index put contracts, the options that act like insurance policies on stocks because they gain value when shares sink, have jumped this year to the highest levels on record relative to bullish calls. In one example, an option that appreciates if the market slides 10 percent by July has seen its cost shoot more than 120 percent above the corresponding bet on a rally. That’s twice the average spread since 2005.

 

In a bull market that hasn’t seen a 10 percent correction since 2011, it makes sense that prices are higher to protect equity holdings. But more may be at work. Rocky Fishman, an equity derivatives strategist at Deutsche Bank AG, says hedging costs are going up as dealers are crimped by regulations and self-imposed risk controls stemming from the financial crisis…

 

Divergences in price between bearish and bullish options can be seen all around the market. Puts expiring in July on the SPDR S&P 500 ETF Trust, the most popular U.S. exchange-traded fund, cost on average 105 percent more than calls this year, compared with 81 percent in 2014, Bloomberg data show.

 

Three-month protection against a 10 percent drop in the Powershares QQQ Trust, the largest fund tracking technology stocks, were priced 93 percent above bullish options as of April 10, Bloomberg data show. That spread has averaged 51 percent since 2009.

 

“Said simply, insurance costs more today than in the past since there are less folks carrying the insurance book,” Scott Maidel, an equity-derivatives portfolio manager in Seattle at Russell Investments, said in an interview April 7.

Of course a simple supply/demand approach seems to indicate that there’s likely more at play here than regulatory pressure. That is, all else equal, when demand for something rises, you can charge more for it, and so if downside protection is now twice as expensive as betting on further upside, it likely means there are more people looking to express a cautious view of prevailing market conditions than there are people looking to get bullish via long calls (we assume delta hedging on the supply side of the equation leaves demand as the only explanation). Barclays apparently agrees:

Nervousness in the market is growing as investors try to figure out when the Federal Reserve will raise interest rates, according to Barclays Plc’s Maneesh Deshpande. That’s the primary reason for higher hedging costs, he said.

 

“Increased bank regulations have probably resulted in tighter risk limits,” Deshpande, head of equity derivatives strategies at Barclays, said by phone April 7.

 

“So it appears logical that it is one of the reasons skew is high. However, based on data, that does not appear to be the only explanation.”

We'll close with the following quote from Goldman which Bloomberg cites as evidence that it's all about the regulators but which certainly seems to suggest that no one wants to be left holding the bag when the inevitable correction rears its ugly head: 

“The Federal Reserve checks all of your trading books on a given day and they say ‘what’s the risk?' The last thing you want to do is sell $5 billion in downside puts the day [the Fed] taps you on the shoulder."