Hedging Update — BAC, F, AMD, GE, WFC

On Bloomberg TV Monday afternoon, markets reporter Adam Johnson noted that put protection had gotten more expensive since a week ago. That has been the case, as the the Chicago Board Options Exchange Market Volatility Index (VIX) has been above 20 since late last week. You can see examples of put protection getting more expensive in the table below. I shows the costs, as of Monday afternoon, of hedging 20 of the most actively-traded stocks against greater-than-20% declines over the next several months, using the optimal puts.


Comparisons


For comparison purposes, I've also added the costs of hedging the SPDR S&P 500 Trust ETF (SPY), the SPDR Dow Jones Industrial Average ETF (DIA) and the Nasdaq 100-tracking ETF PowerShares QQQ Trust ETF (QQQ) against the similar declines. First, a reminder about what optimal puts mean in this context and why I've used 20% as a decline threshold.


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). 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.


Decline Thresholds


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 Intraday Monday


The data in the table below is as of Monday afternoon.


*Based on optimal puts expiring in December, 2011.


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