The Chicago Board Options Exchange Market Volatility Index (VIX) dropped 9.91% Wednesday, to close at 17.27. The table below shows the costs, as of Wednesday's close, of hedging 18 of the 20 most actively-traded ETFs against greater-than-20% declines over the next several months, using the optimal puts for that. First, a reminder about why I've used 20% as a decline threshold, what optimal puts mean in this context, and a quick note about why there were no optimal puts for two of these ETFs.
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:
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).
Why There Were No Optimal Puts for VXX and TZA
In some cases, the cost of protection may be greater than the loss you are looking to hedge against. That was the case with iPath S&P 500 VIX Short-Term (VXX, Financial) and the Direxion Daily Small Cap Bear 3X (TZA, Financial). As of Wednesday's close, the cost of protecting against greater-than-20% declines in those stocks over the next several months was itself greater than 20%. Because of that, Portfolio Armor indicated that no optimal contracts were found for them.
Hedging Costs as of Wednesday
The data in the table below is as of Wednesday's close. The ETFs are listed in order of trading volume Wednesday, with the most actively-traded name (SPY, Financial) at the top.
*Based on optimal puts expiring in December, 2011.
**Based on optimal puts expiring in January, 2012.
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).
Why There Were No Optimal Puts for VXX and TZA
In some cases, the cost of protection may be greater than the loss you are looking to hedge against. That was the case with iPath S&P 500 VIX Short-Term (VXX, Financial) and the Direxion Daily Small Cap Bear 3X (TZA, Financial). As of Wednesday's close, the cost of protecting against greater-than-20% declines in those stocks over the next several months was itself greater than 20%. Because of that, Portfolio Armor indicated that no optimal contracts were found for them.
Hedging Costs as of Wednesday
The data in the table below is as of Wednesday's close. The ETFs are listed in order of trading volume Wednesday, with the most actively-traded name (SPY, Financial) at the top.
Symbol | Name | Cost of Protection (as % of position value) |
SPY | SPDR S&P 500 | 1.17%* |
XLF | Financial Select Sector SPDR | 2.16%* |
IWM | iShares Russell 2000 Index | 2.23%* |
QQQ | PowerShares QQQ | 1.35%* |
EEM | iShares MSCI Emerging Markets | 2.42%* |
EWJ | iShares MSCI Japan | 1.74%* |
VXX | iPath S&P 500 VIX Short-Term | No optimal puts at this threshold |
EFA | iShares MSCI EAFE Index | 2.18%* |
FAS | Direxion Daily Financial Bull 3X | 16.3%** |
SLV | iShares Silver Trust | 5.23%** |
SDS | ProShares UltraShort S&P 500 | 2.95%* |
VWO | Vanguard Emerging Markets | 2.91%* |
TZA | Direxion Daily Small Cap Bear 3x | No optimal puts at this threshold |
XLE | Select Sector SPDR -- Energy | 1.97%* |
FXI | iShares FTSE China 25 Index | 2.17%** |
XLI | Industrial Select Sector SPDR | 1.66%* |
USO | United States Oil | 3.25%** |
SSO | ProShares Ultra S&P 500 | 7.51%* |
SMH | Semiconductor HOLDRs | 4.22%** |
XLB | Materials Select Sector SPDR | 2.06%* |
*Based on optimal puts expiring in December, 2011.
**Based on optimal puts expiring in January, 2012.