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The Dow closed at 11,269.02, up 1.13% on Friday, August 12th, and the Chicago Board Options Exchange Market Volatility Index (VIX) declined 6.77%, to 36.36 on the day. To illustrate how this level of volatilty affects hedging costs, I've included two tables below.

Hedging the Dow with the VIX at 36.36 and at 23.66

The first table below shows the costs, as of Friday August 12th's close, of hedging 29 of 30 Dow components, and the Dow-tracking ETF (NYSEARCA:DIA), against greater-than-20% declines over the next several months, using optimal puts. The second table shows the hedging costs of these names as of Monday, August 2nd, when the Chicago Board Options Exchange Market Volatility Index (VIX) closed at 23.66. First, a reminder about what optimal puts mean in this context, why I've used 20% as a decline threshold, and an explanation for why there were no optimal puts for one of the Dow components on August 12th.

About 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). 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.

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. When hedging, cost is always a concern, which is where optimal puts come in.

A Step by Step Example

You can find 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 BAC on August 12th

In some cases, the cost of protection may be greater than the loss you are looking to hedge against. That was the case with Bank of America (BAC). On Friday, the cost of protecting against a greater-than-20% decline in BAC shares 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 Friday, August 12th, with the VIX at 36.36

The data in the table below is as of Friday's close.

Symbol

Name

Cost of Protection (as % of Position value)

AA

Alcoa Inc. Common Stock

8.40%*

AXP

American Express

6.79%*

BA

Boeing

6.23%**

BAC

Bank of America

No Optimal Puts at this Threshold

CAT

Caterpillar

7.35%**

CSCO

Cisco Systems

4.69%*

CVX

Chevron

5.58%***

DD

E.I. du Pont de Nemours

4.01%*

DIS

Walt Disney

5.53%*

GE

General Electric

7.05%***

HD

Home Depot

4.45%**

HPQ

Hewlett-Packard

5.14%**

IBM

International Business Machines

2.23%*

INTC

Intel

3.39%*

JNJ

Johnson & Johnson

1.69%*

JPM

JP Morgan Chase

10.0%***

KFT

Kraft Foods

2.59%***

KO

Coca-Cola

1.61%**

MCD

McDonald's

2.94%***

MMM

3M

3.20%*

MRK

Merck

3.41%*

MSFT

Microsoft

3.11%*

PFE

Pfizer

5.77%*

PG

Procter & Gamble

1.34%*

T

AT&T

2.76%*

TRV

Travelers

4.30%*

UTX

United Technologies

5.94%**

VZ

Verizon Communications

3.18%*

WMT

Wal-Mart Stores

2.61%***

XOM

Exxon Mobil

2.79%*

DIA

SPDR Dow Jones Industrial Average ETF

3.41%***

*Based on optimal puts expiring in January, 2012.

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

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

Hedging Costs as of Monday, August 2nd, with the VIX at 23.66

The data in the table below is as of August 2nd's close.

Symbol

Name

Cost of Protection (as % of Position value)

AA

Alcoa Inc. Common Stock

3.86%*

AXP

American Express

3.24%*

BA

Boeing

3.60%**

BAC

Bank of America

8.05%**

CAT

Caterpillar

4.32%**

CSCO

Cisco Systems

4.11%*

CVX

Chevron

3.32%***

DD

E.I. du Pont de Nemours

2.56%*

DIS

Walt Disney

3.33%*

GE

General Electric

5.23%***

HD

Home Depot

3.62%**

HPQ

Hewlett-Packard

3.49%**

IBM

International Business Machines

1.37%*

INTC

Intel

3.01%*

JNJ

Johnson & Johnson

1.07%*

JPM

JP Morgan Chase

4.62%***

KFT

Kraft Foods

2.18%***

KO

Coca-Cola

0.93%**

MCD

McDonald's

2.14%***

MMM

3M

2.32%*

MRK

Merck

3.26%*

MSFT

Microsoft

2.09%*

PFE

Pfizer

3.37%*

PG

Procter & Gamble

0.96%*

T

AT&T

1.80%*

TRV

Travelers

1.56%*

UTX

United Technologies

2.94%**

VZ

Verizon Communications

1.53%*

WMT

Wal-Mart Stores

2.79%***

XOM

Exxon Mobil

1.52%*

DIA

SPDR Dow Jones Industrial Average ETF

1.97%***

*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.

Source: Hedging the Dow Components