With stocks tumbling on weak consumer spending news Tuesday, hedging costs for some of the stocks and ETFs we've been following ticked up on the day. The table below shows the costs as of Tuesday's close of hedging eight of the most widely held ADRs 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 (SPY), the SPDR Dow Jones Industrial Average ETF (DIA), the Vanguard Emerging Markets Stock Vipers ETF (VWO), and the Vanguard Europe Pacific ETF (VEA) against the similar declines. First, a reminder about why I've used 20% as a decline threshold, and what optimal puts mean in this context.
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 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 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 on the web, 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.
A Step by Step Example
There is a step by step example of finding optimal puts for a security, with screen shots, in this recent Seeking Alpha article, "Hedging Against a 50% Market Drop."
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. Coincidentally, the hedging costs were the same for the two different Vanguard ETFs below.
Cost of Protection (as % of position value)
America Movil SA de CV
|(ITUB)||Itau Unibanco Holding S.A.||7.65%***|
|(VOD)||Vodafone Group plc||2.91%*|
Vanguard Emerging Markets ETF
|(VEA)||Vanguard Europe Pacific ETF||3.84%***|
SPDR S&P 500
|(DIA)||SPDR Dow Jones Industrial Avg.||2.37%***|
*Based on optimal puts expiring in January, 2012.
**Based on optimal puts expiring in February, 2012.
***Based on optimal puts expiring in March, 2012.