Volatility and Hedging Costs
A point we'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.
At the end of the fourth straight down week for stocks, the Chicago Board Options Exchange Market Volatility Index (VIX) closed at 43.05. In an article published a month ago ("Hedging the NYSE's Most Active Names"), when the Chicago Board Options Exchange Market Volatility Index was at 19.09, we looked the cost of hedging the most actively-traded New York Stock Exchange stocks against greater-than-20% declines over the next several months using optimal puts. In this post, we'll compare the current hedging costs of the same basket of stocks, with volatility more than twice as high.
For comparison purposes, I've also added the costs of hedging the SPDR S&P 500 Trust ETF (SPY), the SPDR Dow Jones Industrial Average ETF (DIA) and the Nasdaq 100-tracking ETF PowerShares QQQ Trust ETF (QQQ) against the similar declines. First, a reminder about what optimal puts mean in this context, and why I've used 20% as a decline threshold.
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
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".
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.
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).
Hedging Costs as of July 20th, with the VIX at 19.09
The data in the table below is as of Wednesday, July 20th's close. After the three ETFs listed for comparison purposes, the stocks are listed in order of their share volume in that day's trading, with the most actively traded stock, Bank of America (BAC), listed first.
Cost of Protection (as % of position value)
SPDR S&P 500
|(DIA)||SPDR Dow Jones Industrial Avg||1.37%**|
|(QQQ)||PowerShares QQQ Trust||2.10%**|
|(BAC)||Bank of America Corporation||6.70%**|
|(GE)||General Electric Company||2.87%**|
|(NLC)||Nalco Holding Company||0.84%*|
|(WFC)||Wells Fargo & Co.||3.38%**|
|(S)||Sprint Nextel Corporation||5.97%**|
|(JPM)||JPMorgan Chase & Co||3.32%**|
|(HK)||Petrohawk Energy Corporation||0.78%**|
|(MO)||Altria Group, Inc.||2.01%**|
*Based on optimal puts expiring in December, 2011
**Based on optimal puts expiring in January, 2012.
Hedging Costs as of August 19th, with the VIX at 43.05
The data in the table below is as of Friday, August 19th's close. The same securities are listed in the same order as the table above, for comparison purposes.
Why There Were No Optimal Puts for 4 of these stocks on August 19th
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), Sprint Nextel Corporation (S), Alcatel Lucent (ALU), AMR Corporation (AMR). On Friday, the cost of protecting against a greater-than-20% decline in those stocks over the next several months was itself greater than 20%. Because of that, Portfolio Armor indicated that no optimal contracts were found for them.
Cost of Protection (as % of position value)
SPDR S&P 500
|(DIA)||SPDR Dow Jones Industrial Avg||4.73%***|
|(QQQ)||PowerShares QQQ Trust||5.03%***|
|(BAC)||Bank of America Corporation||No optimal puts at this threshold|
|(GE)||General Electric Company||9.87%***|
|(NLC)||Nalco Holding Company||10.6%***|
|(WFC)||Wells Fargo & Co.||9.67%*|
|(S)||Sprint Nextel Corporation||No optimal puts at this threshold|
|(JPM)||JPMorgan Chase & Co||11.6%***|
|(HK)||Petrohawk Energy Corporation||1.94%***|
|(MO)||Altria Group, Inc.||4.08%***|
|(ALU)||Alcatel Lucent||No optimal puts at this threshold|
|(AMR)||AMR Corporation||No optimal puts at this threshold|
*Based on optimal puts expiring in January, 2012.
**Based on optimal puts expiring in February, 2012.
***Based on optimal puts expiring in March, 2012.