With reports that BRIC countries were in talks to buy eurozone debt on Tuesday, the major stock indexes advanced on the day. The Nasdaq Composite rose 1.49%, to close at 2,532.15, and the Chicago Options Exchange Market Volatility Index (VIX) dropped 4.35% to close at 36.91. The VIX has closed above 30 every day since the market meltdown of August 5th.
The table below shows the costs, as of Tuesday'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 (SPY) against a similar decline. The Nasdaq 100-tracking ETF PowerShares QQQ Trust ETF (QQQ) is also included, as it was on Nasdaq's most active list as of Tuesday. 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 stocks listed below.
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 using one of the stocks listed below, Microsoft (MSFT).
Step 1: Enter a ticker symbol. In this case, we're using MSFT, 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 MSFT 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 MSFT they cover, so that the total value of the 731 shares of MSFT 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 MSFT against a greater-than-20% drop between now and April 20, 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 mentioned above, the VIX closed at 36.91 on Tuesday. On June 7, when the VIX was at 18.07, the cost of hedging MSFT against a greater-than-20% decline over the same length of time was 2.58% of position value, as we noted in this article published the following day. As the screen shot below shows, on Tuesday, the cost as a percentage of position was 5.72%.
Why There Were No Optimal Contracts for MU or BRCD
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. (MU), and Brocade Communications (BRCD). As of Tuesday, the cost of protecting against greater-than-20% declines in 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
Aside from the ETF (SPY) listed at the bottom for comparison purposes, the names are listed in order of their share volume in Tuesday's trading, with the most actively traded name, Cisco Systems (CSCO), listed first.
Cost of Protection (as % of position value)
|(QQQ)||PowerShares QQQ Trust ETF||4.01%**|
|(MU)||Micron Technologies Inc.||No Optimal Contracts|
|(GLBL)||Global Industries, Ltd.||5.12%**|
|(AMAT)||Applied Materials, Inc.||8.62%***|
|(RIMM)||Research in Motion Limited||14.6%**|
|(FITB)||Fifth Third Bancorp||13.4%*|
|(BRCD)||Brocade Communications||No Optimal Contracts|
|(MRVL)||Marvell Technology Group, Ltd.||7.89%*|
SPDR S&P 500
*Based on optimal puts expiring in February, 2012
**Based on optimal puts expiring in March, 2012
***Based on optimal puts expiring in April, 2012.