Volatility and Hedging Costs of Widely Traded ADRs

by: David Pinsen

Volatility and Hedging Costs

We noted the effect of volatility on hedging costs in a recent article ("Rising Volatility and Hedging Costs"). A look at the hedging costs of a basket of widely traded ADRs on Tuesday and a week before offers another illustration.

With Tuesday's rally, the Chicago Board Options Exchange Market Volatility Index (VIX) closed at 35.06, down 27% from its close of 48 on Monday, but still up 41% from its close at 24.79 a week earlier. The first table below shows the costs as of Tuesday, August 2nd, of hedging eight of the most widely held ADRs against greater-than-20% declines over the next several months, using the optimal puts; the second table shows the cost of hedging the same 8 ADRs against the same percentage declines as of Tuesday, August 9th.


For comparison purposes, I've also included the SPDR S&P 500 Trust ETF (NYSEARCA:SPY), the SPDR Dow Jones Industrial Average ETF (NYSEARCA:DIA), the Vanguard Emerging Markets Stock Vipers ETF (NYSEARCA:VWO), and the Vanguard Europe Pacific ETF (NYSEARCA:VEA) in both tables. First, a reminder about why I've used 20% as a decline threshold, what optimal puts mean in this context, and why there were no optimal puts for one of the comparison ETFs this week.

Decline Thresholds

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

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 Ph.D. 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).

Why There Were No Optimal Puts for VEA This Week

In some cases, the cost of protection may be greater than the loss you are looking to hedge against. That was the case with the Vanguard Europe Pacific ETF (VEA) this week. As of Tuesday, August 9th, the cost of protecting against a greater-than-20% decline in VEA over the next several months was itself greater than 20%. Because of that, Portfolio Armor indicated that no optimal contracts were found for it.

Hedging Costs as of August 2, With the VIX at 24.79

The data in the table below is as of Tuesday, August 2nd'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


(NASDAQ:TEVA) Teva Pharmaceuticals 9.87%***




(NYSE:VALE) Vale S.A. 4.53%***
(NASDAQ:BIDU) Baidu, Inc. 10.43%***




(NYSE:ITUB) Itau Unibanco Holding S.A. 7.65%***
(NASDAQ: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%***

Hedging Costs as of August 9, With the VIX at 35.06

The data in the table below is as of Tuesday, August 9th's close.



Cost of Protection (as % of position value)


America Movil SA de CV


(TEVA) Teva Pharmaceuticals 5.63%***




(VALE) Vale S.A. 11.3%***
(BIDU) Baidu, Inc. 13.4%***




(ITUB) Itau Unibanco Holding S.A. 18.1%***
(VOD) Vodafone Group plc 3.76%*


Vanguard Emerging Markets ETF


(VEA) Vanguard Europe Pacific ETF No Optimal Puts At This Threshold


SPDR S&P 500


(DIA) SPDR Dow Jones Industrial Avg. 2.60%***

*Based on optimal puts expiring in January, 2012.

**Based on optimal puts expiring in February, 2012.

***Based on optimal puts expiring in March, 2012.

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