A drop in volatility on an up day
The Nasdaq Composite climbed 2.49% on Friday, but volatility remained relatively high. After a 10.49% drop in the Chicago Board Options Exchange Market Volatility Index (VIX), it closed at 35.59 on the day, nearly double its levels of late July. The table below shows the costs, as of Friday's close, of hedging 18 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 Friday. 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 names below.
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.
A Step by Step Example
Here is a step by step example of finding the optimal puts for the first ETF listed below, QQQ.
Step 1: Enter a ticker symbol
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 QQQ 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 QQQ they cover, so that the total value of the 631 shares of QQQ would be protected against a greater-than-20% decline.
Click to enlarge
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.
Click to enlarge
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 QQQ 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 35.59 on Friday. On May 25th, when the VIX was at 17.07, the cost of hedging QQQ against a >20% decline over the same length of time was only 1.64%, as we noted in this article published the following day. As the screen shot below shows, as of Friday, the cost as a percentage of position was 3.95%.
Why There Were No Optimal Puts for MU and OVTI
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) and OmniVision Technologies Inc. (NASDAQ:OVTI). As of Friday, 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 them.
Hedging Costs as of Friday'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 Friday's trading, with the most actively traded name (PowerShares QQQ Trust ETF (QQQ)) listed first.
Cost of Protection (as % of position value)
|(QQQ)||PowerShares QQQ Trust ETF||3.95%***|
|(MU)||Micron Technologies Inc.||No Optimal Contracts|
|(OVTI)||OmniVision Technologies Inc.||No Optimal Contracts|
|(RIMM)||Research in Motion||17.1%***|
|(NASDAQ:AMAT)||Applied Materials, Inc.||6.15%*|
|(NASDAQ:ARUN)||Aruba Networks, Inc.||17.0%*|
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 puts on DIA as a hedge.