Hedging Update

Hedging when volatility is low


Something I've mentioned in previous posts (e.g., this one) is that investors ought to consider hedging when volatility is low, and hedging costs are relatively low as well. That's not the case now, as you can see from the second table below. Nevertheless, judging by Portfolio Armor downloads and subscriptions, every day the market tanks, more investors start thinking about hedging. It seems like some investors start shopping for umbrellas after they get soaked.


If Tim Knight's dead cat bounce scenario comes to pass, maybe volatility will come down briefly then and investors will get another chance to hedge at relatively low cost before the next leg down.


Hedging with the VIX at 16.27 and at 43.05


The first table below shows the costs as of Thusday, April 14th, when the VIX was at 16.27, of hedging a basket of widely held stocks and ETFs against greater-than-20% declines over the next several months, using optimal puts; the second table shows the cost of hedging the same basket of stocks and ETFs against the same percentage declines as of Friday, August 19th, with the VIX at 43.05.


First, a reminder about why I've used 20% as a decline threshold, and what optimal puts mean in this context.


Decline Thresholds


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 is not so large that it precludes a recovery. When hedging, cost is always a concern, which is where optimal puts come in.


Optimal Puts


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 -- you can enter any percentage you like, but the larger the percentage, the greater the chance there will be optimal puts available for the position). 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 Step by Step Example


There is a step by step example of finding optimal puts for a security, with screen shots, in this recent Seeking Alpha article: "Hedging Against a 50% Market Drop."


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 April 14th, with the VIX at 16.27


The data in the table below is as of Friday, April 14th's close


*Based on optimal puts expiring in September, 2011

**Based on optimal puts expiring in October, 2011

***Based on optimal puts expiring in November, 2011


Hedging Costs as of August 19th, with the VIX at 43.05


The data in the table below is as of Friday, August 19th's close.


Why There Were No Optimal Puts for BAC This Week


In some cases, the cost of protection may be greater than the loss you are looking to hedge against. That was the case with BAC this week. As of Friday, August 19th, the cost of protecting against a greater-than-20% decline in BAC over the next several months was itself greater than 20%. Because of that, Portfolio Armor indicated that no optimal contracts were found for it.


*Based on optimal puts expiring in January, 2012

**Based on optimal puts expiring in February, 2012

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