The table below shows the costs, as of Tuesday's close, for hedging 7 of 10 stocks that advanced on unusually heavy volume against greater-than-20% declines over the next several months using optimal puts.
For comparison purposes, I've also added the costs of hedging the SPDR S&P 500 Trust ETF (NYSEARCA:SPY), the SPDR Dow Jones Industrial Average ETF (NYSEARCA:DIA) and the Nasdaq 100-tracking ETF PowerShares QQQ Trust ETF (NASDAQ:QQQ) against the similar declines. With the debt ceiling talks dragging on, I also added the costs of hedging the iShares Barclays 20+ Year Treasury Bond ETF (NYSEARCA:TLT). First, a reminder about what optimal puts mean in this context and why I've used 20% as a decline threshold.
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 - 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 Ph.D. to sort through and analyze all of the available puts for your position, scanning for the optimal ones (click here for a step by step example).
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).
Hedging Costs as of Tuesday's Close
The data in the table below is as of Tuesday's close. Below the four comparison ETFs, the stocks are listed in order of volume change Tuesday, with the one with the most unusually high volume Interdigital, Inc. (NASDAQ:IDCC) listed first.
Why There Were No Optimal Puts for FXEN or VIVO
In some cases, the cost of protection may be greater than the loss you are looking to hedge against. That was the case with FX Energy, Inc. (NASDAQ:FXEN) and Arctic Cat, Inc. (NASDAQ:ACAT). As of Tuesday, the cost of protecting against a greater-than-20% decline in each of 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.
Cost of Protection (as % of position value)
SPDR S&P 500
|(DIA)||SPDR Dow Jones Industrial Avg||1.40%**|
|(QQQ)||PowerShares QQQ Trust||2.11%**|
|(TLT)||iShares Barclays 20+ Year Treas||0.61%**|
|(NASDAQ:WBMD)||WebMD Health Corp.||8.67%*|
|(NASDAQ:STLD)||Steel Dynamics, Inc.||5.27%**|
|(FXEN)||FX Energy, Inc.||No Optimal Puts At This Threshold|
|(HANS)||Hansen Natural Corporation||4.05%*|
|(ACAT)||Arctic Cat, Inc.||No Optimal Puts At This Threshold|
|(NASDAQ:VIVO)||Meridian Biosciences, Inc.||6.95%**|
*Based on optimal puts expiring in December, 2011.
**Based on optimal puts expiring in January, 2012.
Disclosure: I am long puts on DIA and TLT