Seeking Alpha
Portfolio strategy
Profile| Send Message|
( followers)  

In a Seeking Alpha article last month ("Top 20 High Yielding Dividend Aristocrats"), Insider Monkey posted a list of 20 dividend-paying stocks that had increased their dividends for at least 25 years. The table below shows the costs, as of Wednesday's close, of hedging 19 of those "Dividend Aristocrats" against greater-than-20% declines over the next several months, using optimal puts.

A Comparison

For comparison purposes, I've also added the costs of hedging the SPDR S&P 500 Trust ETF (NYSEARCA:SPY) against a similar decline. 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, Consolidated Edison, Inc. (NYSE:ED).

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, Consolidated Edison, Inc. (ED).

Step 1: Enter a ticker symbol. In this case, we're using ED, 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., 631. In that case, Portfolio Armor would round down the number of shares of ED 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 six of the put option contracts that would slightly over-hedge the 600 shares of ED they cover, so that the total value of the 631 shares of ED 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 ED 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. The VIX closed at 34.60 on Wednesday. On Friday, July 8, when the VIX was at 15.95, the cost of hedging ED against a greater-than-20% decline over the next six months was 0.93% of position value, as we noted in this article published the following Monday. As the screen shot below shows, on Wednesday, the cost of hedging ED against the same decilne over the next five months, as a percentage of position, was 1.77%.



Hedging Costs as of Wednesday's Close

The hedging costs and yields below are as of Wednesday's close.

Dividend Yield

Hedging Cost

CenturyLink Inc

CTL

8.37%

4.90%***

Pitney Bowes Inc. PBI 7.40% 7.25%***

Cincinnati Financial Corp

CINF

5.89%

6.95%**

Leggett & Platt LEG 5.27% 8.94%**

Consolidated Edison Inc

ED

4.24%

1.77%*

Kimberly-Clark Corp. KMB 4.11% 2.93%***

Abbott Laboratories

ABT

3.77%

2.49%*

Clorox Co

CLX

3.51%

4.17%***

Johnson & Johnson JNJ 3.58% 3.30%***
Procter & Gamble PG 3.37 3.24%***

AFLAC Inc

AFL

3.43%

8.30%*

PepsiCo.
PEP 3.35% 2.74%***
PPG Industries, Inc. PPG 3.00% 4.43%*

Emerson Electric Co

EMR

3.07%

7.11%**

Automatic Data Processing, Inc.
ADP 2.92% 3.14%*

Air Products & Chemicals Inc

APD

2.90%

1.65%*

Stanley Black & Decker, Inc. SWK 2.88% 5.24%**
Lowe's Companies, Inc. LOW 2.86% 6.49%***
McDonald's Corp. MCD 2.81% 2.66%**
SPDR S&P 500

SPY

2.10%

3.75%**


*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 19 Top Dividend Aristocrats