Hedging Widely-Traded ADRs

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Includes: AMX, BIDU, DIA, ITUB, PBR, SPY, TEVA, UBS, VALE, VEA, VOD, VWO
by: David Pinsen

The table below shows the costs, as of Thursday's close, of hedging eight of the most widely-held ADRs against greater-than-20% declines over the next several months, using the optimal puts for that.

Comparisons

For comparison purposes, I've also added the costs of hedging the SPDR S&P 500 Trust ETF (SPY), the SPDR Dow Jones Industrial Average ETF (DIA), the Vanguard Emerging Markets Stock Vipers ETF (VWO), and the Vanguard Europe Pacific ETF (VEA) against the similar declines.

First, a reminder about why I've used 20% as a decline threshold, and what optimal puts mean in this context; plus a quick note about times to expiration.

Decline Thresholds

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 is not so large that it precludes a recovery. When hedging, cost is always a concern, which is where optimal puts come in.

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 -- you can enter any percentage you like, but the larger the percentage, the greater the chance there will be optimal puts available for the position). 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.

Times to Expiration

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 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)

(AMX)

America Movil SA de CV

1.82%**

(TEVA) Teva Pharmaceuticals 2.46%***

(UBS)

UBS AG

5.62%***

(VALE) Vale S.A. 4.32%***
(BIDU) Baidu, Inc. 7.62%***

(PBR)

Petrobras

2.61%*

(ITUB) Itau Unibanco Holding S.A. 4.69%***
(VOD) Vodafone Group plc 1.98%*

(VWO)

Vanguard Emerging Markets ETF

3.17%***

(VEA) Vanguard Europe Pacific ETF 3.66%***

(SPY)

SPDR S&P 500

1.41%***

(DIA) SPDR Dow Jones Industrial Avg. 1.19%***
Click to enlarge

*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.

Additional disclosure: I am long some puts on DIA.