Hedging the NYSE's Most Active Names

|
 |  Includes: AAL, BAC, C, DIA, ECL, EMC, F, GE, HK, JPM, KEY, MO, MS, NLC, NOK, PFE, QQQ, S, SPY, T, USB, WFC
by: David Pinsen

As of Wednesday's close, the Chicago Board Options Exchange Market Volatility Index (VIX) had ticked down 0.62% on the day to 19.09. The table below shows the costs, as of Wednesday's close, of hedging the most actively-traded New York Stock Exchange stocks against greater-than-20% declines over the next several months, using optimal puts.

Comparisons

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. First, a reminder about what optimal puts mean in this context, and why I've used 20% as a decline threshold.

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 - 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 (there is a step by step example of that in this article, "Helping House Majority Leader Eric Cantor Hedge his Treasuries Exposure").

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.

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 Wednesday's Close

The data in the table below is as of Wednesday's close. After the three ETFs listed for comparison purposes, the stocks are listed in order of their share volume in Wednesday's trading, with the most actively traded stock Bank of America (NYSE:BAC) listed first.

Symbol

Name

Cost of Protection (as % of position value)

(SPY)

SPDR S&P 500

1.49%**

(DIA) SPDR Dow Jones Industrial Avg 1.37%**
(QQQ) PowerShares QQQ Trust 2.10%**
(BAC) Bank of America Corporation 6.70%**
(NYSE:GE) General Electric Company 2.87%**
(NLC) Nalco Holding Company 0.84%*
(NYSE:WFC) Wells Fargo & Co. 3.38%**
(NYSE:NOK) Nokia Corporation 15.5%**
(NYSE:S) Sprint Nextel Corporation 5.97%**
(NYSE:PFE) Pfizer Inc. 3.07%**
(NYSE:F) Ford 3.67%**
(NYSE:C) Citigroup Inc. 3.86%**
(NYSE:JPM) JPMorgan Chase & Co 3.32%**
(HK) Petrohawk Energy Corporation 0.78%**
(MS) Morgan Stanley 5.11%**
(EMC) EMC Corporation 2.01%**
(ECL) Ecolab, Inc. 4.09%**
(KEY) KeyCorp 5.44%**
(USB) U.S. Bancorp 3.06%**
(MO) Altria Group, Inc. 2.01%**
(NYSE:T) ATT, Inc. 1.52%**
(ALU) Alcatel Lucent 12.7%**
(AMR) AMR Corporation 15.5%**
Click to enlarge

*Based on optimal puts expiring in December, 2011

*Based on optimal puts expiring in January, 2012.

Disclosure: I am long puts on DIA.