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Hedging Update

In the table below, I've updated the costs (as of Thursday's close) of hedging three major index-tracking ETFs against greater-than-20% declines over the several months, using the optimal puts, along with the costs of similarly hedging a handful of their most widely-traded components, and several other ETFs. First, though, a reminder about why I've used 20% as a decline threshold, and what "optimal puts" means in this context.

Decline thresholds

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

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)
Widely-Traded Stocks
INTC Intel 3.86%***
CSCO Cisco Systems 5.29%***
MSFT Microsoft 2.55%***
LVLT Level 3 Communications, Inc. No Optimal Puts at this Threshold
BAC Bank of America 4.32%***
F Ford 3.84%**
GE GE 3.07%**
PFE Pfizer 1.78%**
SIRI Sirius XM Radio 12.98%**
S Sprint Nextel 9.24%***
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%**
Internet ETF
HHHMerrill Lynch Internet HOLDRs2.39%*
Other Sector ETFs
XLFFinancial Select Sector SPDR2.81%**
EEMiShares MSCI Emerging Markets2.74%**


*Based on optimal puts expiring in November, 2011

**Based on optimal puts expiring in December, 2011

***Based on optimal puts expiring in January, 2012

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Comments

batbeer2
Batbeer2 premium member - 3 years ago
Hi Dave

....the cost of protection may be greater than the loss you are looking to hedge against. That was the case with LVLT.

What's the cost of protection against the stock going up ? If my favorite companies become expensive, I'm in trouble.

Buy a business, don’t rent stocks. - Warren Buffett
DaveinHackensack
DaveinHackensack - 3 years ago
Hi Batbeer,

I'm glad you asked.

Protecting against a stock going up is actually a real issue for short sellers, some of whom have asked for Portfolio Armor to add the capability to find optimal calls for that. I'm meeting with the finance Ph.D. who developed Portfolio Armor's original algorithm later this month to discuss adding that additional functionality. If we do add it, I'll have to raise prices on Portfolio Armor going forward, to cover the research & development cost, but I will grandfather current subscribers at the current rate.

Hi Dave

....the cost of protection may be greater than the loss you are looking to hedge against. That was the case with LVLT.

What's the cost of protection against the stock going up ? If my favorite companies become expensive, I'm in trouble.

Buy a business, don’t rent stocks. - Warren Buffett


batbeer2
Batbeer2 premium member - 3 years ago
Thanks for your response.

I'd be interested to see what the "premium" or "cost" for insurance against upward volatility of LVLT looks like. Let's say this too is very high.... am I right in concluding this means the market perceives LVLT to be very volatile ?

In short, would the sum of the two costs be an indication of perceived volatility ?
DaveinHackensack
DaveinHackensack - 3 years ago
That's an interesting question. We know that the call option will increase in value as the underlying price appreciates in a similar way that the put option value goes up when the underlying stock price drops in value; the relationship is highly nonlinear with a similar convexity effect -- the put option value increases at an increasing rate when the stock price falls by a constant amount whereas the call option value increases at an increasing rate when the stock price rises by a constant amount.

As for whether the optimal calls will be as expensive as the puts for stocks such as LVLT, I suspect not, but it will be interesting to see. The one thing I've noticed from recently -- this isn't apparent from the table above, but I'll include these stocks in an all-stock table next week -- is that the hedging costs have tended to be pretty low for stocks you would intuitively consider to be conservative, or low risk (e.g., KFT).

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