Hedging the ETF Volume Leaders

May.29.11 | About: iPath S&P (VXX)

The table below shows the costs, as of Friday's close, of hedging 19 of the 20 ETFs with the highest trading volume, against greater-than-20% declines over the next several months. The model uses the optimal puts for that. First, a reminder about why I've used 20% as a decline threshold, and what optimal puts mean in this context, plus an explanation of why there were no optimal puts for one of these ETFs.

Decline Thresholds

The idea for a 20% threshold, as I've mentioned before, comes 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.

Why there were no optimal puts for VXX

In some cases, the cost of protection may be greater than the loss you are looking to hedge against. That was the case with VXX. As of Friday, the cost of protecting against a greater-than-20% decline in the ETF over the next several months was itself greater than 20%. Because of that, Portfolio Armor indicated that no optimal contracts were found for it.

Hedging costs as of Friday's close

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

Symbol

Name

Cost of Protection (as % of position value)

(NYSEARCA:SPY)

SPDR S&P 500

1.36%***

(XLF) Financial Select Sector SPDR 1.85%***

(IWM)

iShares Russell Index 2000

2.14%**

(EEM) iShares MSCI Emerging Markets 2.66%***
(EWJ) iShares MSCI Japan Index 2.97%***

(SLV)

iShares Silver Trust

5.08%*

(QQQ) PowerShares QQQ Trust 1.57%***
(UNG) US Natural Gas 3.92%*

(EFA)

iShares MSCI EAFE Index

1.97%***

(XLE) Energy Select Sector SPDR 2.17%***

(VWO)

Vanguard Emerging Markets

2.48%***

(VXX) .iPath S&P 500 VIX Short-Term
No Optimal Puts at this threshold
(XLI) Industrial Select Sector SPDR 2.04%***
(SDS) ProShaes UltraShort S&P 500 2.44%***
(EWZ) iShares MSCI Brazil Index 2.91%***
(XLK) Technology Select Sector SPDR 1.88%***
(TZA) Direxion Russell 2000 Bearish 17.7%*
(FAS) Direxion Russell 1000 Financials 9.74%*
(XLB) Materials Select Sector SPDR 2.36%***
(GLD) SPDR Gold Trust 0.53%***
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.