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A Down Day for the Dow

The Dow closed at 11,240.26, down 2.2% on Friday, September 2nd, and the Chicago Board Options Exchange Market Volatility Index (VIX) rose 6.6%, to 33.92 on the day. The VIX has closed above 30 every day since the market meltdown of August 4th.

Hedging the Dow

The table below shows the costs, as of Friday's close, of hedging 29 of the 30 Dow components, and the Dow-tracking ETF (DIA), against greater-than-20% declines over the next several months, using optimal puts. First, a reminder about what optimal puts mean in this context, and a step by step example of finding the optimal puts for one of these components.

About 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 Dow listed below, The Coca-Cola Company (KO).

Step 1: Enter a ticker symbol. In this case, we're using KO, 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., 731. In that case, Portfolio Armor would round down the number of shares of KO 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 seven of the put option contracts that would slightly over-hedge the 700 shares of KO they cover, so that the total value of the 731 shares of KO 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 KO against a >20% drop between now and February 17, 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 33.92 on Friday. On March 28, when the VIX was at 19.44, the cost of hedging KO against a >20% decline over the same length of time was only 0.75%, 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 1.56%.

Why There Were No Optimal Puts for BAC

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). On Friday, the cost of protecting against a greater-than-20% decline in BAC shares over the next several months was itself greater than 20%. Because of that, Portfolio Armor indicated that no optimal contracts were found for it.

Hedging Costs as of Friday's Close

The data in the table below is as of Friday's close.

Symbol

Name

Cost of Protection (as % of Position value)

(AA)

Alcoa Inc. Common Stock

10.1%***

(AXP)

American Express

7.32%***

(BA)

Boeing

4,84%*

(BAC)

Bank of America

No Optimal Contracts

(CAT)

Caterpillar

7.14%*

(CSCO)

Cisco Systems

7.72%***

(CVX)

Chevron

5.24%**

(DD)

E.I. du Pont de Nemours

6.33%***

(DIS)

Walt Disney

5.58%***

(GE)

General Electric

7.04%**

(HD)

Home Depot

3.60%*

(HPQ)

Hewlett-Packard

8.01%*

(IBM)

International Business Machines

3.59%***

(INTC)

Intel

5.60%***

(JNJ)

Johnson & Johnson

3.12%***

(JPM)

JP Morgan Chase

8.63%**

(KFT)

Kraft Foods

2.48%**

(KO)

Coca-Cola

1.56%*

(MCD)

McDonald's

2.11%**

(MMM)

3M

5.29%***

(MRK)

Merck

4.79%***

(MSFT)

Microsoft

4.73%***

(PFE)

Pfizer

4.71%**

(PG)

Procter & Gamble

3.07%***

(T)

AT&T

4.28%***

(TRV)

Travelers

6.96%***

(UTX)

United Technologies

4.11%*

(VZ)

Verizon Communications

3.82%***

(WMT)

Wal-Mart Stores

2.46%**

(XOM)

Exxon Mobil

5.82%***

(DIA)

SPDR Dow Jones Industrial Average ETF

3.38%**

*Based on optimal puts expiring in February, 2012

**Based on optimal puts expiring in March, 2012

***Based on optimal puts expiring in April, 2012

Source: Hedging The Dow This Labor Day Weekend