Although U.S. equity futures spiked Sunday night as news of the killing of Osama Bin Laden broke, the Dow Jones Industrial Average, NASDAQ, and S&P 500 all closed lower Monday (Jeff Sutherland and Rita Nazareth of Bloomberg, pinned the decline on valuation concerns overshadowing news of Bin Laden's death).
Volatility rose Monday, with the VIX up 8.41% to 15.99 -- still lower than it was when we we looked at hedging the NASDAQ 100 last month (via the PowerShares QQQ ETF) and its 10 most actively traded components (back then, the VIX was at 16.9). Nevertheless, as today's action in the VIX shows, Volatility can spike quite quickly, so if you are considering hedging, you may want to consider doing so while volatility remains relatively low.
The table below shows the updated costs, as of Monday's close, of hedging the NASDAQ 100, via its tracking ETF QQQ, and 10 of its most actively traded components against greater-than-20% declines over the next several months, using the optimal puts to do so. For comparison purposes, I've also added the costs of hedging the S&P 500-tracking ETF SPY, and the Dow-tracking ETF DIA against the same decline. First, a reminder about what optimal puts mean in this context, and why I've used 20% as a decline threshold, plus a quick note about the time frames involved here.
Optimal puts are the ones that will give you the level of protection you want at the lowest possible cost. With Portfolio Armor (available in Seeking Alpha's Investing Tools Store, 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 Ph.D. candidate to sort through and analyze all of the available puts for your position, scanning for the optimal ones.
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.
A quick note regarding the time frames involved in the table below: In his research, the finance academic who developed Portfolio Armor's algorithm found that options with approximately six months to expiration (which today would be the ones expiring in November) tend to offer the best combination of liquidity and cost, so those are the put options for which Portfolio Armor's algorithm aims. When puts with about six months to expiration are not available, Portfolio Armor searches for slightly longer or shorter times to expiration.
Note that, unlike in last month's table, when the hedging costs of the index ETFs QQQ, SPY, and DIA were based on optimal puts expiring in October, this time they are based on optimal puts expiring in December (December 29th, to be exact, so that's almost 8 months of insurance from today). All things equal, options with expirations further out generally cost more.
Symbol | Name | Cost of Protection (as % of position value) |
(INTC) | Intel | 1.88%* |
(CSCO) | Cisco Systems | 2.45%* |
(MSFT) | Microsoft | 1.44%* |
(ORCL) | Oracle | 3.44%*** |
(NVDA) | Nvidia | 10.5%*** |
(MU) | Micron Technologies | 7.56%* |
(AMAT) | Applied Materials | 3.37%* |
(QCOM) | Qualcomm | 2.1%* |
(DELL) | Dell | 3.17%** |
(AAPL) | Apple | 2.12%* |
(QQQ) | PowerShares QQQ Trust | 2.05%*** |
(SPY) | SPDR S&P 500 | 1.7%*** |
| (DIA) | SPDR Dow Jones Industrial Average | 1.4%*** |
*Based on optimal puts expiring in October, 2011.
**Based on optimal puts expiring in November, 2011.
***Based on optimal puts expiring in December, 2011.
Disclosure: I am long some puts on DIA.
