Wednesday, January 27, 2010

SPY vs SDS as a hedge

So this morning I paid $2.13 for 5 SPY Feb '10 put contracts. At around the same time, if instead, I wanted to hedge using the 2x inverse SDS ETF I could have got the $36 calls for $1.80.

In my analysis I looked at a 5% down move in the SPY, which would be about a 10% up move in SDS. This allowed me to see how many contracts I would have to buy of SDS to get the same protection that I got from the SPY puts.

What I found was that I would need to buy 6 of the SDS $36 calls to have about the same protection that the SPY was providing. This would cost about $1080. The SPY puts cost $1065. So the cost differential is not enough to choose SDS over SPY. Next if you look at the P&L analysis below you will notice that there is again not much of a differential. The only advantage that the SDS has over the SPY puts is that if price stays the same you lose about $40 less.

Note: When you look at the analysis below, remember that a 5% move in the SPY is 2x that in the SDS.

I then increased and decreased volatility by 10% to see what effect that would have on both positions. I chose these two scenarios as price and volatility have an inverse relationship. So as you increase volatility you see that the SPY acts much more favorable and there is a significant gap between the performance or effectiveness of the SPY vs the SDS as a hedge. Then when I decreased the volatility you see that SDS is a little more favorable with a move to the downside. But I almost want to ignore this scenario because in more cases than not as price declines volatility would rise. But the big difference that stands out between the SPY and SDS is if price stays the same you lose half as much with SDS.

Conclusion: From the analysis, the take away I got is that the SPY puts in my opinion are more effective in the actual hedging. Since you are buying the protection for downward movement you are going to want the option that delivers the most protection. So I would choose SPY puts over SDS.

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