As I've mentioned before, the threshold I usually use when I hedge is 20% (i.e., I want protection against any decline worse than that). The idea for a 20% threshold came from a comment fund manager (and Stanford finance Ph.D.) John Hussman made in October 2008:
An intolerable loss, in my view, is one that requires a heroic recovery simply to break even… a short-term loss of 20%, particularly after the market has become severely depressed, should not be at all intolerable to long-term investors because such losses are generally reversed in the first few months of an advance (or even a powerful bear market rally).
Optimal puts are the ones that will give you the level of protection you want at the lowest possible cost. With Portfolio Armor (available as a web app, and an iOS app) you just enter the symbol of the stock or ETF you’re looking to hedge, the number of shares you own, and the maximum decline you’re willing to risk, (your threshold). Then the app uses an algorithm developed by a finance Ph.D. to sort through and analyze all of the available puts for your position, scanning for the optimal ones.
A note about costs
To be conservative, Portfolio Armor calculates hedging costs using the ask price of the optimal puts. In many cases, you may be able to buy the puts for a lower cost (between the bid and the ask prices).
Why there were no optimal puts for LVLT
In some cases, the cost of protection may be greater than the loss you are looking to hedge against. That was the case with LVLT. As of Thursday, the cost of protecting against a greater-than-20% decline in the stock over the next several months was itself greater than 20%. Because of that, Portfolio Armor indicated that no optimal contracts were found for it.
Costs of hedging against >20% declines, as of Thursday's close
|Symbol||Name||Cost of Protection (as % of Position value)|
|LVLT||Level 3 Communications, Inc.||No Optimal Puts at this Threshold|
|BAC||Bank of America||4.32%***|
|SIRI||Sirius XM Radio||12.98%**|
|Major Index ETFs|
|QQQ||PowerShares QQQ Trust||1.73%**|
|SPY||SPDR S&P 500||1.35%**|
|DIA||SPDR Dow Jones Industrial Average||1.11%**|
|Precious Metals ETFs|
|GLD||SPDR Gold Trust||0.37%**|
|SLV||iShares Silver Trust||6.90%***|
|SGOL||ETFS Physical Swiss Gold Shares||2.22%**|
|SIVR||ETFS Physical Silver Shares||7.27%**|
|HHH||Merrill Lynch Internet HOLDRs||2.39%*|
|Other Sector ETFs|
|XLF||Financial Select Sector SPDR||2.81%**|
|EEM||iShares MSCI Emerging Markets||2.74%**|
*Based on optimal puts expiring in November, 2011
**Based on optimal puts expiring in December, 2011
***Based on optimal puts expiring in January, 2012