Despite a 4.69% rally in the Nasdaq Composite on Thursday, volatility remained relatively high. The Chicago Board Options Exchange Market Volatility Index (VIX) closed at 39 on the day. The table below shows the costs, as of Thursday's close, of hedging 19 of the 20 most actively traded Nasdaq names 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) and the SPDR Dow Jones Industrial Average ETF (NYSEARCA:DIA) against similar declines. The Nasdaq 100-tracking ETF PowerShares QQQ Trust ETF (NASDAQ:QQQ) is also included, as it was on Nasdaq's most active list as of Thursday. First, a reminder about what optimal puts mean in this context, why I've used 20% as a decline threshold, plus a quick note about why there were no optimal puts for one of the 20 most active Nasdaq names.
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). 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.
You can enter any percentage you like for a threshold when using the tool (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.
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 MU
In some cases, the cost of protection may be greater than the loss you are looking to hedge against. That was the case with Micron Technologies Inc. (NASDAQ:MU). As of Thursday, the cost of protecting against a greater-than-20% decline in MU 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 Thursday's Close
Aside from the two ETFs (SPY and DIA) listed at the bottom for comparison purposes, the names are listed in order of their share volume in Thursday's trading, with the most actively traded name (Cisco Systems (NASDAQ:CSCO)) listed first.
Cost of Protection (as % of position value)
|(QQQ)||PowerShares QQQ Trust ETF||4.33%***|
|(MU)||Micron Technologies Inc.||No Optimal Puts at this Threshold|
|(NASDAQ:AMAT)||Applied Materials, Inc.||5.38%*|
|(RIMM)||Research in Motion||11.1%***|
|(NASDAQ:FITB)||Fifth Third Bancorp||8.11%**|
|(NASDAQ:HBAN)||Huntington Bancshares Inc.||15.4%*|
|(NASDAQ:VOD)||Vodaphone Group, Plc||3.97%*|
SPDR S&P 500
|(DIA)||SPDR Dow Jones Industrial Avg.||3.06%***|
*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 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.