In a post on Wednesday, June 29th ("How you know the negotiations have truly failed"), Washington Post blogger Ezra Klein suggested that given the lack of progress in the debt-ceiling negotiations,

...all in all, this might be a good time to follow [House Majority Leader Rep.] Eric Cantor’s lead and hedge your exposure to treasuries.

**Hedging with an inverse ETF**

Klein's blog post linked a Wall Street Journal MarketBeat column which noted that Majority Leader Cantor held "up to $15,000 in shares of the 2x levered ProShares Trust Ultrashort 20+ Year Treasury ETF (TBT)". That column quoted Cantor's spokesman as saying that Cantor held "a lot of Treasury debt", and that his TBT position merely hedged some of it.

**How much of a hedge is Rep. Cantor's TBT position?**

That would depend, in part, on how large Rep. Cantor's exposure to Treasuries is. How much Treasury debt does Rep. Cantor own? Let's do a quick back-of-the-envelope estimate of that. GovTrack.us reports that Eric Cantor’s net worth was between $2,182,171 and $7,106,000 in 2007, according to Cantor’s mandated financial disclosure statements. Let's assume his actual net worth is midway between those two numbers, $4,644,126. How much of that might be in U.S. Treasuries? Let's assume Eric Cantor found the Beginners' Guide to Asset Allocation on the SEC's website, and clicked over to the Iowa Public Employees Retirement System asset allocation calculator that page links to.

If you enter Rep. Cantor's age, estimated net worth, and income into that calculator, and assign him an average risk tolerance, that calculator recommends a 10% allocation to taxable bonds. It doesn't break that down between corporate bonds and government bonds, but for simplicity's sake, let's assume Rep. Cantor has 10% of his money exposed to U.S. Treasuries. Using our net worth estimate above, that would be about $464,000.

A more precise way to hedge

As we mentioned in a post in May ("Optimal Puts versus Inverse ETFs for Hedging"), precision is one of the advantages of using optimal puts, rather than inverse ETFs, to hedge:

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)

The example above mentions a stock, but Rep. Cantor could find optimal puts on a U.S. Treasuries-tracking ETF, such as the iShares Barclays 20+ Year Treasury Bond ETF (TLT). Let's walk through how Rep. Cantor could find the optimal puts to hedge his Treasury exposure.

**Step one**: **enter a ticker symbol**

If Rep. Cantor were to use TLT as a proxy for his Treasury exposure, he'd enter "TLT" in the first field on Portfolio Armor:

**Step two: enter a number of shares**

Our back-of-the-envelop estimate above was that Cantor had $464,000 invested in U.S. Treasuries. On Friday afternoon, TLT traded at $93.42, so about 4,967 shares of TLT would equal $464,000. So Rep. Cantor might enter "4967" in the second field on Portfolio Armor:

**Step three: enter a decline threshold**

This number would depend on Rep. Cantor's risk tolerance -- it represents the largest decline he would be willing to risk. In previous posts on hedging, I've mentioned why I usually use 20% as a decline threshold, but let's assume Cantor has a slightly lower risk tolerance and wasn't willing to risk a greater-than-18% decline. In that case, he would enter "18%" in the threshold field:

**Step four: click the button**

A moment after clicking the red "Add" button, Rep Cantor would see the screen below, showing him the optimal puts to hedge against a greater-than-18% decline in TLT between now and late January (a long enough time frame to hedge against Seeking Alpha contributor Martin Hutchinson's prediction that September and December will be the most likely months for a bond market crash). Note that the cost of this protection would be $3,969, or 0.86% of our estimate of Cantor's position in U.S. Treasuries (or funds which invest in them). (2) It's also less than a third of the amount of money he currently has allocated to his inverse Treasury ETF.

(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) To be conservative, Portfolio Armor quoted that cost based on the ask price of the optimal puts. In practice, an investor can often purchase puts for a lower price, i.e., some price between the bid and the ask.

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