Optimal puts are the ones that will give you the level of protection you want at the lowest possible cost. As University of Maine finance professor Dr. Robert Strong, CFA has noted, picking the most economical puts can be a complicated task. With Portfolio Armor (available on the web, and as an Apple 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 academic to sort through and analyze all of the available puts for your position, scanning for the optimal ones (there's an example of this, with screen shots, in this recent article regarding the last ETF in the table below, TLT).
You can enter any percentage you like for a threshold when using Portfolio Armor (the higher the percentage though, the greater the chance you will find optimal puts for your position). The idea for a 20% threshold comes, as I've mentioned before, from a comment fund manager John Hussman made in a market commentary 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).
Essentially, 20% is a large enough threshold that it reduces the cost of hedging but not so large that it precludes a recovery. When hedging, cost is always a concern, which is where optimal puts come in.
How Costs Are Calculated
To be conservative, Portfolio Armor calculated the costs below based on the ask prices of the optimal put options. In practice, though, an investor may be able to buy some of these put options for less (i.e., at a price between the bid and the ask).
Hedging costs as of Thursday
The data in the table below is as of Thursday's close. The ETFs are listed in order trading volume Thursday, with the most actively-traded name (SPY) at the top.
|Symbol||Name||Cost of Protection (as % of position value)|
|SPY||SPDR S&P 500||1.10%*|
|IWM||iShares Russell 2000 Index||2.25%*|
|EWJ||iShares MSCI Japan||1.78%*|
|EEM||iShares MSCI Emerging Markets||2.25%*|
|XLF||Financial Select Sector SPDR||1.92%*|
|XLI||Industrial Select Sector SPDR||1.85%*|
|XLE||Select Sector SPDR -- Energy||2.10%*|
|EFA||iShares MSCI EAFE Index||2.03%*|
|EWZ||iShares MSCI Brazil Index||3.86%*|
|USO||United States Oil||3.52%*|
|XLK||Technology Select Sector SPDR||1.39%*|
|XLB||Materials Select Sector SPDR||2.66%*|
|EWT||iShares MSCI Taiwan Index||2.61%*|
|IYR||iShares Dow Jones Real Estate||1.92%*|
|XLU||Utilities Select Sector SPDR||0.97%*|
|XLY||Consumer Discretionary SPDR||1.59%*|
|XLV||Health Care Select SPDR||1.11%*|
|XLP||Consumer Staples Select SPDR||0.75%*|
|TLT||iShares Barclays 20+ Yr. Treas.||0.74%*|
*Based on optimal puts expiring in January, 2012.