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"Doomsday" Defense Cuts

In an AP article on Monday ("'Doomsday' defense cuts loom large for select 12"), Donna Cassata raised the prospect of automatic defense spending cuts kicking in if the 12-member Congressional super committee fails to agree on other spending cuts as required by the debt ceiling deal, or if they come to an agreement but it doesn't get approved by the full Congress:

The panel has until Thanksgiving to come up with recommendations. If they deadlock or if Congress rejects their proposal, $1.2 trillion in automatic, across-the-board cuts kick in. Up to $500 billion would hit the Pentagon.

Those cuts, starting in 2013, would be in addition to the $350 billion, 10-year reduction already dictated by the debt-limit bill approved by Congress and signed into law by President Barack Obama this month.

Not surprisingly, Defense Secretary Leon Panetta has described the automatic cuts as the "doomsday mechanism."

Hedging Against "Doomsday" Defense Cuts

Cassata's article listed four contractors that would be hit by these "Doomsday" cuts, General Dynamics Corporation (NYSE:GD), Lockheed Martin (NYSE:LMT), Northrop Grumman (NYSE:NOC), and Raytheon (NYSE:RTN) . Below is a step-by-step example of how to hedge one of these companies, Raytheon (RTN) with optimal puts, followed by a table showing the current costs of hedging the rest of them in a similar manner. First though, a note about volatility and hedging costs, and a reminder about what optimal puts mean in this context.

Volatility and Hedging Costs

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. The hedging costs below are as of Monday, August 16th, when the Chicago Board Options Exchange Market Volatility Index (VIX) closed at 31.87.

Hedging Costs With the VIX at 15.52 vs. at 31.87

For an idea of how hedging costs can vary with volatility, compare the current cost of hedging the SPDR Dow Jones Industrial Average ETF (NYSEARCA:DIA) against a >20% over the next 7 months as of Monday, with the VIX at 31.87, to the costs of hedging DIA against the same decline over 7 months back in May, when the VIX was at 15.52. In the table below, you'll see the current cost of that level of protection on DIA is 3.57% of your position value; back in May, when the VIX was at 15.52, it was only 1.27%, which is why I wrote, in an article at the time ("An Update on Hedging the Dow"):

Volatility has ticked up slightly since then [April], with the VIX closing at 15.52 on Thursday, still fairly close to its 52-week low of 14.27 though (its 52-week high was 48.2). Volatility can spike quite quickly though, so if you are considering hedging, you may want to consider doing so while volatility remains relatively low.

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 (also available 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.

A Step by Step Example of Hedging Raytheon

Step 1: Enter a ticker symbol

In this case, we're hedging Raytheon, so we've entered RTN in the "Ticker Symbol" field in the screen cap below (click to enlarge images):

Step 2: Enter a number of shares

For this example, we'll assume the investor has 1,000 shares of RTN, so we've entered that number in the "Shares Owned" field in the screen cap below. Note that you could also enter an odd number here (e.g., 1,087), in which case Portfolio Armor would round that down to the nearest hundred (since one put option contract represents the right to sell one hundred shares of the underlying security), and then present you with 10 of the put option contracts that would slightly over-hedge the 1000 shares of RTN they cover, so that the total value of your 1087 shares of RTN would be protected against the decline threshold you enter in Step 3.

Step 3: Enter a decline threshold

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. So we've entered 20% in the Threshold field in the screen cap below.

Step 4: Click the red button

A moment after clicking the red button, you'd see the screen cap below, which shows the optimal put option contracts to buy to hedge 1000 shares of RTN against a >20% drop between now and February 17th, 2012. The cost of this protection would be about $1,390, or about 3.37% of your position value.

Note that, to be conservative, Portfolio Armor calculated the cost based on the ask price of the optimal puts. In practice an investor can often purchase puts for a lower price, i.e., some price between the bid and the ask.

Hedging Costs of All Four Defense Contractors

The table below shows the costs, as of Monday's close, of hedging the four defense contractors mentioned above against >20% declines. For comparison purposes, I've also included the cost of hedging the Dow-tracking ETF DIA.

Symbol

Name

Cost of Protection (as % of position value)

(GD)

General Dynamics Corporation

4.94%**

(LMT) Lockheed Martin 3.91%***

(NOC)

Northrop Grumman

5.28%**

(RTN) Raytheon Company 3.37%**
(DIA) SPDR Dow Jones Industrial Avg. 3.57%***

**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.

Source: Hedging Against Doomsday Defense Cuts