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A point I've made in previous articles (such as "Another Alternative to A Defensive Portfolio") is that, if an investor is considering hedging, it's better to consider doing so when volatility is relatively low and hedging costs are relatively low. With the Chicago Board Options Exchange Market Volatility Index (VIX) closing at a new year-to-date high of 32 on Friday, I thought it might be instructive to compare the costs of hedging the same set of index-tracking ETFs on Friday with the costs of hedging them at an earlier point, when the VIX was nearly 50% lower.

Hedging costs with the VIX at 17.16 versus 32

The first table below shows the costs of hedging the SPDR S&P 500 ETF (NYSEARCA:SPY), the SPDR Dow Jones Industrial Average ETF (NYSEARCA:DIA), and the PowerShares QQQ Trust ETF (NASDAQ:QQQ) against greater-than-20% declines, using optimal puts, when the VIX was at 17.16; the second table shows the costs of hedging the same index-tracking ETFs against the same declines using optimal puts with the VIX at 32. First, though, a reminder about what optimal puts mean in this context, and a note about time frames.

About optimal puts

Optimal puts are the ones that will give you the level of protection you specify 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). Then the app uses an algorithm developed by a finance PhD 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 the recent Seeking Alpha article, "Hedging Against a 50% Market Drop."

A note about time frames

Primarily for purposes of liquidity and cost, Portfolio Armor aims for options with approximately six months to expiration. When puts with about six months to expiration are not available, Portfolio Armor searches for slightly longer or shorter times to expiration. In each of the tables below, the hedging costs are based on optimal puts with a little over 7 months to expiration.

Hedging costs as of May 9, with the VIX at 17.16

The hedging costs in this table were first posted in this article on May 10.

Symbol

Name

Cost of Protection (as % of position value)

SPY

SPDR S&P 500

1.77%*

DIA SPDR Dow Jones Industrial Avg 1.49%*
QQQ PowerShares QQQ Trust 2.11%*

Hedging costs as of August 5, with the VIX at 32.

Symbol

Name

Cost of Protection (as % of position value)

SPY

SPDR S&P 500

3.56%**

DIA SPDR Dow Jones Industrial Avg 3.06%**
QQQ PowerShares QQQ Trust 3.30%**

*Based on optimal puts expiring in December 2011.

**Based on optimal puts expiring in March 2012.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: I am long optimal puts on DIA as a hedge.

Source: Rising Volatility and Hedging Costs