Ten Stocks That Advanced on Unusual Volume
The table below shows the costs, as of Tuesday's close, for hedging 6 of 10 stocks that advanced on unusually heavy volume 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 (SPY) and the Nasdaq 100-tracking ETF PowerShares QQQ Trust ETF (QQQ). First, a reminder about what optimal puts mean in this context, then a step by step example of finding optimal puts for the first of the comparison ETF.
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 one of the comparison ETFs listed below, QQQ.
Step 1: Enter a Ticker Symbol
In this case, we're using QQQ, so we've entered it in the "Ticker Symbol" field below:
[Click images to enlarge]
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.
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 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. The VIX S&P 500 volatility index closed at 32.89 on Tuesday. 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 GIFI, OVTI, JAZZ, or ZOLL
In some cases, the cost of protection may be greater than the loss you are looking to hedge against. That was the case with Gulf Island Fabrication, Inc. (GIFI), Omnivision Technologies, Inc. (OVTI), Jazz Pharmaceuticals, Inc., (JAZZ), or Zoll Medical Corp., (ZOLL). As of Tuesday, the cost of protecting against a greater-than-20% decline in each of 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.
Hedging Costs As Of Tuesday's Close
Below the ETFs listed for comparison purposes, the stocks below are listed in order of volume change Tuesday, with the one with the most unusually high volume, Gulf Island Fabrication, Inc., listed first.
Cost of Protection (as % of position value)
SPDR S&P 500
|QQQ||PowerShares QQQ Trust||3.57%***|
|GIFI||Gulf Island Fabrication, Inc.||No Optimal Contracts|
|MNRO||Monro Muffler Brake, Inc.||4.44%*|
|JCOM||J2 Global Communications, Inc.||10.3%***|
|OVTI||Omnivision Technologies, Inc.||No Optimal Contracts|
|SHLM||A. Schulman, Inc.||9.67%*|
|DLLR||Dollar Financial Corp.||7.05%*|
|JAZZ||Jazz Pharmaceuticals, Inc.||No Optimal Contracts|
|ZOLL||Zoll Medical Corp.||No Optimal Contracts|
|FCFS||First Cash Financial Services||4.90%***|
*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.