Hedging Equity Risk May Stay Costly as Usual Havens Misfire

Hedging exposure to the S&P 500 index via options is going to remain costly yet vital next year due to the pandemic and relative lack of protection from traditional havens, Tallbacken Capital Advisors LLC said.

“Vaccine volatility” is likely because of the winding paths ahead to the eventual introduction of an inoculation or other therapies, according to Tallbacken CEO Michael Purves. That means strategies such as buying put options on the U.S. equity gauge “can continue to be a very expensive proposition,” he said.

“The magical disappearance of Covid is not a binary event, but a process,” he wrote in note. “The longer this process continues, the more sustained economic uncertainty will be.”

Some investors are vexed by the performance of usual portfolio stabilizers such as Treasuries or gold. Rather than providing a hedge, both have fallen amid a two-month tumble in the S&P 500 from a record that coincided with failed U.S. fiscal stimulus talks, uncertainty ahead of the presidential election and accelerating virus cases.

Hedging Equity Risk May Stay Costly as Usual Havens Misfire

In one view, U.S. sovereign debt doesn’t offer the buffer it once did because yields are already so low, potentially making options-market strategies more important for hedging equity risk.

While stocks can still climb against a background of uncertainty caused by the coronavirus outbreak, “market hedging is all the more important given that traditional safe havens are not working the way they usually do,” Purves said.

The cost of seeking such protection climbed ahead of the election on fears of a drawn-out or contested result. Purves’s argument suggests investors expecting the situation to normalize rapidly after the vote may face disappointment.

Some investors may have already shifted toward cash, worn down by the election and the escalating pandemic.

The S&P 500’s 5.6% drop last week shows “markets are bracing for the fear of the unknown” and “whittling down rich positions to hold cash,” according to a note from Vishnu Varathan, head of economics and strategy at Mizuho Bank Ltd.

©2020 Bloomberg L.P.

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