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After rising 6.13% on Friday, the Chicago Board Options Exchange Market Volatility Index (VIX) ticked up another 3.98% Monday. The table below shows the costs, as of Moday's close, of hedging 17 of the 20 most actively-traded Nasdaq names against greater-than-20% declines over the next several months, using the optimal puts for that.


For comparison purposes, I've also added the costs of hedging the SPDR S&P 500 Trust ETF (NYSEARCA:SPY) and the SPDR Dow Jones Industrial Average ETF (NYSEARCA:DIA) against the similar declines. The Nasdaq 100-tracking ETF PowerShares QQQ Trust ETF (NASDAQ:QQQ) is also included, as it was on Nasdaq's most active list as of Monday. First, a reminder about what optimal puts mean in this context, why I've used 20% as a decline threshold, plus

Optimal Puts

Optimal puts are the ones that will give you the level of protection you want at the lowest possible cost. As University of Maine finance professor Dr. Robert Strong, CFA has noted, picking the most economical puts can be a complicated task. 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 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.

How Costs Are Calculated

To be conservative, Portfolio Armor calculated the costs below based on the ask prices of the optimal put options. In practice, though, an investor may be able to buy some of these put options for less (i.e., at a price between the bid and the ask).

Why There Were No Optimal Puts for LVLT, MU, and SINA

In some cases, the cost of protection may be greater than the loss you are looking to hedge against. That was the case with Level 3 Communications (LVLT), Micron Technologies Inc. (MU), and Sina Corporation (NASDAQ:SINA). As of Monday, the cost of protecting against greater-than-20% declines in those stocks over the next several months was itself greater than 20%. Because of that, Portfolio Armor indicated that no optimal contracts were found for them.

Hedging Costs as of Monday's Close



Cost of Protection (as % of position value)

(NASDAQ:CSCO) Cisco Systems 6.11%**
(LVLT) Level 3 Communications No optimal puts at this threshold
(NASDAQ:MSFT) Microsoft 2.58%**
(NASDAQ:INTC) Intel Corporation 4.39%**
(MU) Micron Technologies Inc. No optimal puts at this threshold
(QQQ) PowerShares QQQ Trust ETF 1.65%*
(NYSE:ORCL) Oracle 3.45%*
(NASDAQ:DELL) Dell, Inc. 5.45%**
(NASDAQ:CMCSA) Comcast Corporation 3.67%**
(YHOO) Yahoo! Inc. 7.28%**
(FITB) Fifth Third Bancorp 6.68%**
(NASDAQ:NWSA) News Corporation 5.54%**
(NVDA) NVIDIA Corporation 8.12%*
(RIMM) Research in Motion, Ltd. 8.56%*
(SINA) Sina Corporation No optimal puts at this threshold
(NASDAQ:SPLS) Staples, Inc. 4.34%*
(NASDAQ:AAPL) Apple, Inc. 3.23%**
(NASDAQ:EBAY) eBay, Inc. 7.87%**
(NASDAQ:SIRI) Sirius XM Radio Inc. 18.32%*
(AMAT) Applied Materials, Inc. 5.45%**


SPDR S&P 500


(DIA) SPDR Dow Jones Industrial Avg. 1.22%*

*Based on optimal puts expiring in December, 2011.

**Based on optimal puts expiring in January, 2012.

Disclosure: I am long puts on DIA.