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A drop in volatility on an up day

The Chicago Board Options Exchange Market Volatility Index (VIX) dropped 14.54% Tuesday, closing at 36.27, as stocks rose and the Dow had its best day in two weeks. The table below shows the costs, as of Tuesday's close, of hedging 8 of the 10 most actively traded ETFs against greater-than-20% declines over the next several months, using optimal. First, a reminder about what optimal puts mean in this context, then a step by step example of finding optimal puts for the most actively traded of the ETFs below.

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

Here is a step by step example of finding the optimal puts for the first ETF listed below, SPY.

Step 1: Enter a ticker symbol

In this case, we're using SPY, so we've entered it in the "Ticker Symbol" field below:

Step 2: Enter a number of shares

For simplicity's sake, we've entered 100 in the "shares owned" field below, but you could also enter an odd number, e.g., 631. In that case, Portfolio Armor would round down the number of shares of SPY you entered 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 6 of the put option contracts that would slightly over-hedge the 600 shares of SPY they cover, so that the total value of the 631 shares of SPY would be protected against a greater-than-20% decline.




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: Tap the "Done" button

A moment after tapping the blue button, you'd see the screen cap below, which shows the optimal put option contracts to buy to hedge 100 shares of SPY against a >20% drop between now and March 16, 2012. Two notes about these optimal put options and their cost:

  • 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.
  • As volatility has climbed, so have hedging costs. As we noted above, the VIX S&P 500 volatility index closed at 36.27 on Tuesday. On May 25th, when the VIX was at 17.07, the cost of hedging SPY against a >20% decline over the same length of time was only 1.34%, as we noted in this article published the following day. As the screen shot below shows, as of Tuesday, the cost as a percentage of position was 3.94%.

Why There Were No Optimal Put Option Contracts for FAS and FAZ

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 Direxion Daily Financial Bull 3X ETF (NYSEARCA:FAS) and the iPath Short-Term VIX Futures ETF (NYSEARCA:VXX) and the Direxion Daily Financial Bear 3X ETF (NYSEARCA:FAZ). As of Tuesday, the cost of protecting against greater-than-20% declines in those ETFs over the next several months was itself greater than 20%. Because of that, Portfolio Armor indicated that no optimal contracts were found for them.

Hedging Costs as of Tuesday

The data in the table below is as of Tuesday's close. The ETFs are listed in order of trading volume Tuesday, with the most actively-traded name (NYSEARCA:SPY) at the top.

Symbol

Name

Cost of Protection (as % of position value)

SPY

SPDR S&P 500

3.94%***

XLF Financial Select Sector SPDR 8.81%***
IWM iShares Russell 2000 Index 4.94*%**
QQQ PowerShares QQQ Trust 4.02%***
FAS Direxion Daily Financial Bull 3X No Optimal Contracts
EEM iShares MSCI Emerging Index 6.09%***
SDS UltraShort S&P 500 ProShares 11.8%***
XLE Energy Select SPDR 6.03%***
XLI Industrial Select Sector SPDR 5.29%***
FAZ Direxion Daily Financial Bear 3X No Optimal Contracts

**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.

Source: The Most Active ETFs And Their Hedging Costs