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In our last post on hedging ("Hedging Against the Bursting of internet Bubble 2.0"), we looked at hedging Internet stocks and ETFs. In this post, we’ll look at hedging the DJIA (via the SPDR Dow Jones Industrial Average ETF DIA) and its components. But first, it’s worth asking why an investor might consider hedging now. Two reasons come to mind:

1) Hedging has gotten cheaper recently, as volatility has declined. As of March 28th, the VIX was back below 20, after spiking up to around 30 earlier this month, a few trading days after the 2011 Tōhoku earthquake and tsunami hit Japan.

2) Prudence may be warranted with the end of QE2 scheduled for the end of June. On Bloomberg TV Monday, David Rosenberg, chief economist at Gluskin Sheff & Associates (formerly chief North American economist at Merrill Lynch noted the correlation between the Fed’s quantitative easing and the direction of U.S. stocks during the current cyclical bull market off of the March ‘09 lows:

It’s one thing to have a fundamentally-based bull market: they tend to last for many, many years. But liquidity: it’s there one minute and can be gone the next minute [...] In the past two years there’s been an 88% correlation between the movements in the Fed balance sheet and the direction of the S&P 500. If the Fed embarks on some exit strategy in the second half of the year, much like they did for a temporary period last year, it will be interesting to see how the market responds once QE2 runs its course if QE3 doesn’t follow suite in June or July

Rosenberg went on to say that he thought there would be a QE3, but that it might not come until this time next year.

With that in mind, below is a table showing the current costs of hedging each Dow component, and the Dow-tracking ETF (NYSEARCA:DIA), against greater-than-20% declines over the next several months using the optimal puts (I used the Portfolio Armor iPhone app to pull up the optimal puts for these securities, but you can also use the web app versions of Portfolio Armor available in Seeking Alpha's Investing Tools Store). First though, a reminder of what “optimal” means in this context, and a note about the time frames involved. The optimal put options are the ones that will give an investor the level of protection he or she wants at the lowest possible cost. Portfolio Armor uses a proprietary algorithm developed by an all-but-dissertation finance Ph.D. candidate to find the optimal contracts to hedge stocks and ETFs.

In his research, the Ph.D. candidate who developed the algorithm found that options with approximately 6 months to expiration tend to offer the best combination of liquidity and cost, so those are the puts for which Portfolio Armor’s algorithm aims. When puts with about six months to expiration aren’t available, Portfolio Armor searches for slightly longer or shorter times to expiration. In the table below, unless marked with an asterisk, the optimal put option contracts for the security expire in September; one asterisk indicates the options expire in August; two asterisks indicate that the options expire in October. All things equal, one would expect options with less time to expiration to be less expensive, and ones with more time to expiration to be more expensive.

(Click chart to expand)



Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: I have a limit order in to buy the optimal puts on DIA referred to above.

Source: Hedging the Dow