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In an article last month, we noted that Bank of America Corporation (BAC) had been frequently been the most expensive stock in the Dow to hedge with optimal puts:

Since late March, I've updated the hedging costs of each Dow component, and the SPDR Dow Jones Industrial Average ETF (NYSEARCA:DIA), using optimal puts, seven times. In five of those seven posts, starting with this one published on April 21 [based on data as of April 20], "Hedging the Dow, an Update," BAC had the highest hedging costs of any Dow component.

In that article, we also identified the three other Dow components with the highest optimal hedging costs on April 20, and the four with the lowest optimal hedging costs on that day, and compared the performance of both groups of stocks over the subsequent four months. Noting how the stocks with highest optimal hedging costs underperformed those with the lowest optimal hedging costs, we speculated that high optimal hedging cost might be a red flag for a stock.

We qualified that speculation, mentioning that we'd need to see a lot more data before using this as a basis for picking stocks, but I thought it would be interesting to take a look at BAC's optimal hedging costs again now, after the Warren E. Buffett news.

Bank of America after Buffett's capital Injection

The big news for BAC since that article was published last month has been Buffett's $5 billion preferred stock investment in it. One might assume that that deal would assuage some investors' concerns over Bank of America's balance sheet, but a look at the cost of hedging Bank of America with optimal puts now suggests otherwise.

Hedging costs of BAC and its competitors

The table below shows the costs, as of Thursday's close, of hedging Bank of America and its industry competitors JP Morgan Chase & Co. (JPM), Wells Fargo & Co. (WFC), and Citigroup, Inc. (C), 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 over the next several months against the same declines. First, a reminder about what optimal puts mean in this context, then a step by step example of finding optimal puts for one of the comparison ETFs.

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). 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, DIA.

Step 1: Enter a ticker symbol. In this case, we're using DIA, so we've entered it in the "Ticker Symbol" field below:

[Click all 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., 837. In that case, Portfolio Armor would round down the number of shares of DIA 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 eight of the put option contracts that would slightly over-hedge the 800 shares of DIA they cover, so that the total value of the 837 shares of DIA 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 DIA 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 31.83 on Thursday. On May 25, when the VIX was at 17.07, the cost of hedging DIA against a >20% decline over the same length of time, as a percentage of position, was only 1.24%, as we noted in this article published the following day. As the screen shot below shows, as of Thursday, the cost as a percentage of position was 3.18%.

Hedging costs as of Thursday's close

As the table below shows, even after Buffett's $5 billion preferred stock investment in the company, optimal hedging costs for Bank of America remain extremely high, both in absolute terms and relative to its competitors.

Symbol

Name

Cost of Protection (as % of Position value)

BAC

Bank of America

18.1%*

JPM

JP Morgan Chase

8.40%**

WFC Wells Fargo & Co. 9.99%***
C Citigroup, Inc. 13.0%**
SPY SPDR S&P 500 Trust ETF 3.43%**

DIA

SPDR DJIA ETF

3.18%***

*Based on optimal puts expiring in February, 2012.

**Based on optimal puts expiring in March, 2012

***Based on optimal puts expiring in April, 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 optimal puts on DIA.

Source: Red Flag For Bank Of America?