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In a Seeking Alpha article last month, Sy Harding made a good point about the lack of downside protection offered by defensive stocks:

The failure of defensive stocks to protect portfolios has been demonstrated over and over again. But the advice remains the same in every cycle.

After the market seemed to top out in the year 2000, the stocks most recommended as defensive stocks included Alcoa (AA), Bristol Myer Squibb (BMY), Citigroup (C), Coca-Cola (KO), Disney (DIS), DuPont (DD), Fannie Mae (OTCQB:FNMA), General Electric (GE), Home Depot (HD), IBM (IBM), Merck (MRK), and WalMart (WMT). However, they plunged an average of 59% to their lows in the 2000-2002 bear market, worse than the Dow's decline of 38% and the S&P 500 decline of 49%.

Optimal Puts Versus Inverse ETFs

Harding suggested a different tack to provide downside protection for an investor's portfolio: inverse ETFs. Inverse ETFs can be a useful tool, but there are a few reasons why investors may want to consider using optimal puts to provide downside protection for their portfolios (a quick reminder: optimal puts are the ones which will give you the exact level of protection you want at the lowest possible cost):

  • Ability to hedge against idiosyncratic (or, stock-specific) risk. Say you own a particular stock and you are unwilling or unable to sell some of your stake in it to reduce your downside risk. If the stock has options traded on it, you may be able to use optimal puts to hedge against a decline due to an event specific to that stock. Inverse ETFs can be used to offset market risk or industry risk, but not stock-specific risk. For example, if you owned BP (BP) when the Deepwater Horizon disaster happened last year, owning optimal puts on it could have limited your downside as BP plummeted over the next few months, but owning shares of the ProShares Short Oil & Gas ETF (DDG) wouldn't have, as that inverse ETF declined over the next few months as well.
  • Precision. Say you own 821 shares of Kraft Foods, Inc. (KFT), and you'd like to know how to hedge that position against a greater-than-18% loss. Using Portfolio Armor (which is available in the Seeking Alpha Investing Tools Store and also as an Apple iOS app), you could simply enter "KFT" in the symbol field, "821" in the number of shares field, and "18%" in the threshold field, and then Portfolio Armor would use its algorithm to scan for the optimal puts to give you that level of protection at the lowest cost. (1)
  • Ability to cap cost at the outset. It's not always clear how investors who use inverse ETFs decide how much of their portfolios to allocate to them -- I've asked Inverse ETF investors about this in the past, and in response have been told they "feel comfortable with" some small percentage. To use a round number here, let's say an investor decided to allocate 10% of his portfolio to an unleveraged, inverse index ETF, such as ProShares Short Dow 30 (DOG), to provide him some downside protection against a market correction. What if the index went on to stage a rally instead -- what if it went up another 25% over the next several months? In that case, the investor's portfolio might be 2.5% lower than it would have been had he not purchased that downside protection. What if, instead, the investor bought the optimal puts to hedge against a greater-than-20% decline in the ETF that tracks the Dow, the SPDR Dow Jones Industrial Average (DIA)? As of Wednesday's close, the cost of those optimal puts was 1.19%; if the investor bought enough of those optimal puts to hedge his whole portfolio, their drag on his performance in the event of a 25% market rally would be capped at 1.19%. (2)

Volatility and Hedging Costs

It's worth noting that, in that last case, part of the reason the optimal puts on DIA are so cheap is that volatility is still relatively low. On the two year chart of the VIX below, you can see that the volatility index is well below the levels it hit in March after the disaster in Japan, or last May during the Flash Crash. Volatility can spike quite quickly though, so if you are considering hedging, you may want to consider doing so while volatility remains relatively low.

(Click to enlarge)

(1) In that case, Portfolio Armor would round down the number of shares you entered to the nearest hundred (since one put option contract represents the right to sell one hundred shares of the underlying security), and then present you with nine of the put option contracts that would slightly over-hedge the 800 shares they cover, so that the total value of your 821 shares would be protected against a greater-than-18% loss.

(2) For the sake of simplicity there, I ignored the transaction fees of purchasing the ETF and the options, and I ignored the management fee of the ETF.

Source: Optimal Puts Versus Inverse ETFs for Hedging