Portfolio Armor: Optimized Downside Protection for Your Stocks and ETFs

by: SA Editors

This article is part of a regular series in which we interview our Tool Providers - the folks that develop the amazing stock-market Tools in Seeking Alpha's new Investing Tools platform.

Please use the comment stream below to share your own experiences with the featured Tool. And feel free to suggest to the developers any improvements or changes you'd like to see (or write a review!).

This week, we (SA) interview David Pinsen (DP) of Launching Innovation LLC - whose Investing Tool, Portfolio Armor, helps provides optimal downside protection for stocks and ETFs in your portfolio.

And now, the interview:

SA: How does Portfolio Armor differ from other options tools?

DP: Portfolio Armor is unique in that it shows the optimal put options to buy for you to obtain the precise level of protection that you want at the lowest cost.

SA: What about calculating Black-Scholes or another options pricing model in an Excel spreadsheet instead?

DP: The Black-Scholes formula is used to compute prices and hedge ratios for options. It will not tell you which contracts provide the optimal level of protection to preserve your wealth in a stock or ETF holding, given the market prices.

Options pricing models such as Black-Scholes give hedge ratios which require continuous and dynamic re-balancing of the hedge portfolio. Portfolio Armor maintains a static and conservative hedge ratio, and by taking the cost of the options into account, does so in the most economical way for the investor.

SA: What about just scanning Yahoo! Finance or Morningstar to manually find puts to buy?

DP: A very good, experienced and savvy investor might be able to find the right number of contracts and the right strike price to protect against a certain loss level, but when taking price into account he might be at risk of paying too much for too little coverage.

SA: Can't buying protective puts be expensive?

DP: It can be, depending on the security you are looking to hedge, and other factors, which is why if you are going to buy protective puts you want to make sure you are getting the level of protection you want at the lowest cost. But the costs of protective puts can be minimized by hedging opportunistically, when it is relatively inexpensive to do so. And the costs of not hedging - and suffering permanent losses of capital - can be far higher.

If you decide to hedge, Portfolio Armor can show you how to get the exact level of protection you want at the lowest cost. Whether you should hedge a given security, and what downside risk you should be willing to accept are questions no automated tool can answer and are best discussed with a licensed or registered financial professional.

SA: What does "threshold" mean?

DP: "Threshold" refers to the maximum decline you are willing to risk in your stock or ETF. You can enter this as a dollar value or a percentage, but if you use a percentage please type a "%" after the number.

SA: What's the difference between Portfolio Armor for Individual Investors and Portfolio Armor for Financial Professionals?

DP: There are two main differences: 1) Portfolio Armor for Financial Professionals allows financial professionals to enter and save multiple portfolios, one for each of their clients. 2) Financial Professional subscribers can also enter their professional profiles in a searchable database so individual investor subscribers can search for them if they are looking for professional assistance.

Two versions of the app - one for Individual Investors:

And one for Financial Professionals:

SA: Is the "initial cost" of the put protection what it will cost me to buy those particular put option contracts?

DP: To be conservative, Portfolio Armor calculates initial cost based on the ask price of the put options. In some cases, you may be able to purchase the options for a price between the bid and ask, i.e., one slightly lower than the than the initial cost listed by Portfolio Armor. Bear in mind, though, that Portfolio Armor's initial cost does not include brokerage commissions, which will of course vary depending on the brokerage you use.

SA: Given the up-front cost of using options for protection, what is your position on triggering an options position only if a stock breaches a given threshold?

DP: All things equal, the greater your threshold - i.e., the greater the decline in your stock or ETF that you are willing to risk - the cheaper it will be to hedge. My threshold for a position might be different from yours, but I think John Hussman's concept of "intolerable losses" is worth considering here. Hussman wrote this in a weekly market commentary of his in October of 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)."

Hussman was talking about the market as a whole, but I think his general concept could be applied to individual positions as well. If I am going to hedge an individual stock or ETF, I'm going to set my threshold at just above what I think would be an "intolerable loss" for that particular security.

SA: Does Portfolio Armor have an alert system to let me know if an options position has gone into the money? Does it offer help around optimizing when to exit a position, or is that left up to the user?

SA: Yes, Portfolio Armor does have such an alert system (you can also opt to turn off e-mail alerts). When to exit a put position is left to the user, though if you wanted to maintain protection on your position, you would want to sell your puts after buying ones with maturities further out.

SA: Are there certain positions that are more catered to options protection than others? Have you run any studies as to the net/net effect of investing naked vs. using options to protect positions?

DP: Some positions are certainly less expensive to hedge than others. Index ETFs such as DIA and SPY generally are cheaper to hedge than individual stocks, and more volatile stocks tend to be more expensive to hedge than less volatile ones.

I haven't run studies comparing un-hedged investing versus hedged investing, but I suspect that over the course of a secular bull market, un-hedged investing would outperform hedged investing; and, conversely, over the course of a secular bear or range-bound market, an opportunistically hedged portfolio would outperform an un-hedged one. John Hussman comes to mind here again. He launched his Strategic Growth Fund, which is hedged, in 2000, near the beginning of the current secular bear, or range-bound market. It has outperformed the S&P-tracking ETF SPY over that time frame.

I suspect though that a similar hedged fund would have underperformed SPY over a ten year bull market.

SA: Give us a couple examples of times you or your customers were able to optimize their downside protection using Portfolio Armor.

DP: Last January, I was looking to hedge some market risk, so I used Portfolio Armor to determine the optimal puts to hedge against a greater-than-20% decline in the DJIA-tracking ETF DIA. Then I went ahead and bought those puts.

A few months later, at the end of March, I used Portfolio Armor to look up the optimal puts to protect against a similar decline in SPY, and noted that the cost of that protection was only about 1.3% for six months. A week later, the cost had dropped to 1.1%, so I bought those puts. I thought of that as "buying umbrellas when it's sunny out" (or, hedging opportunistically).

Owning both sets of puts gave me plenty of peace of mind when the Flash Crash occurred less than two months later, in May. I sold the DIA puts in May for a 32% profit, which helped offset the cost of the SPY puts.

SA: Thanks David!

Have any thoughts, suggestions, or comments for David and his team? Tell them, and other SA readers, what you think in the comment stream.

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