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Last month we looked at hedging the DJIA (via the SPDR Dow Jones Industrial Average ETF DIA) and its components. At the time we noted that hedging had gotten less expensive recently, as volatility (as measured by the VIX) had declined to close to its two year low.

Volatility is still low

Volatility has ticked up slightly since then, with the VIX closing at 15.52 on Thursday, still fairly close to its 52-week low of 14.27 though (its 52-week high was 48.2). Volatility can spike quite quickly though, so if you are considering hedging, you may want to consider doing so while volatility remains relatively low.

Hedging the Dow and its components

The table below shows the costs, as of Thursday's close, 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 to do so. 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

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 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.

Times to expiration

A quick note regarding the time frames involved in the table below: In his research, the finance Ph.D. candidate 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 puts 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. 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.

Hedging costs as of Thursday's close

The data in the table below is as of Thursday's close.

Symbol

Name

Cost of Protection (as % of Position value)

(NYSE:AA)

Alcoa Inc. Common Stock

2.94%*

(NYSE:AXP)

American Express

1.78%*

(NYSE:BA)

Boeing

2.45%**

(NYSE:BAC)

Bank of America

3.08%**

(NYSE:CAT)

Caterpillar

3.61%**

(NASDAQ:CSCO)

Cisco Systems

1.74%*

(NYSE:CVX)

Chevron

3.03%***

(NYSE:DD)

E.I. du Pont de Nemours

1.98%*

(NYSE:DIS)

Walt Disney

1.74%*

(NYSE:GE)

General Electric

3.11%***

(NYSE:HD)

Home Depot

1.74%**

(NYSE:HPQ)

Hewlett-Packard

2.10%**

(NYSE:IBM)

International Business Machines

1.01%*

(NASDAQ:INTC)

Intel

2.17%*

(NYSE:JNJ)

Johnson & Johnson

0.83%*

(NYSE:JPM)

JP Morgan Chase

3.16%***

(KFT)

Kraft Foods

1.26%***

(NYSE:KO)

Coca-Cola

1.01%**

(NYSE:MCD)

McDonald's

1.45%***

(NYSE:MMM)

3M

1.41%*

(NYSE:MRK)

Merck

1.23%*

(NASDAQ:MSFT)

Microsoft

1.70%*

(NYSE:PFE)

Pfizer

2.66%***

(NYSE:PG)

Procter & Gamble

0.62%*

(NYSE:T)

AT&T

1.24%*

(NYSE:TRV)

Travelers

1.75%*

(NYSE:UTX)

United Technologies

1.52%**

(NYSE:VZ)

Verizon Communications

1.26%*

(NYSE:WMT)

Wal-Mart Stores

0.92%***

(NYSE:XOM)

Exxon Mobil

1.62%*

(DIA)

SPDR Dow Jones Industrial Average ETF

1.27%***

*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 have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I am holding a few puts on DIA.

Source: An Update on Hedging the Dow