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Hedging Update — Post Debt Ceiling Deal Edition

Hedging costs after the debt deal

Last week, with the debt ceiling negotiations dragging on, we looked at the costs of hedging a handful of equity index, gold-, Treasury bond-, and dollar index-tracking ETFs. Below is a snapshot showing the current hedging costs of the same basket of ETFs.

Hedging against a >30% correction in stocks

The table below shows the costs, as of Wednesday's close, of hedging the same five equity index ETFs against greater-than-30% corrections over the next several months, using optimal puts.

Hedging against a >15% correction in bonds, gold, and the dollar

The table also shows the costs of hedging the same gold-, U.S. dollar-, and Treasury Bond-tracking ETFs against greater-than-15% declines over the next several months using optimal puts. First, a quick reminder about what optimal puts are, and a note about costs, followed by a couple of observations.

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 our previous post, "Hedging against a Dollar Drop." 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).

Hedging Costs as of Wednesday's Close

Symbol Name Cost of Protecting against >30% Decline, as % of position
Equity Index ETFs
QQQ PowerShares QQQ Trust 1.23%*
SPY SPDR S&P 500 0.98%*
DIA SPDR Dow Jones Industrial Avg 0.87%*
EFAiShares MSCI EAFE Index2.62%*
EEMiShares MSCI Emerging Markets1.61%*
SymbolNameCost of Protecting against a >15% Decline, as % of position
U.S Dollar ETF
UUPPowerShares DB US Dollar Index0.38%*
U.S. Treasury Bonds
TLTiShares Barclays 20+ Yr Treas1.47%*
GLD SPDR Gold Trust 1.50%*


Two observations jump out here. The first is that hedging costs of TLT have dropped considerably — 1.47% for about 7.5 months of protection this week versus 1.49% for about 5.5 months of protection last week. That makes sense intuitively, considering that the risk of near term default, however remote it was, is off the table now (though the risk of a downgrade in medium term isn't).

The second observation is that the costs of hedging GLD relative to TLT have jumped this week: 1.50% for GLD versus 1.47% for TLT this week, compared to 0.64% for GLD versus 1.49% for TLT last week.

*Based on optimal puts expiring in March, 2012.

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