Hedging The Most Actively Traded ETFs

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 |  Includes: EEM, EFA, IWM, QQQ, SDS, SPY, TZA, XLF, XLI
by: David Pinsen

As stocks rallied on Thursday on news that central banks would provide European banks with unlimited dollar loans, the Chicago Board Options Exchange Market Volatility Index (VIX) dropped 7.6% to 31.97. That volatility index has still closed over 30 every day since August 5th. The table below shows the costs, as of Thursday's close, of hedging 8 of the 10 most actively traded ETFs against greater-than-20% declines over the next several months, using optimal puts. First, a reminder about what optimal puts mean in this context, then a step by step example of finding optimal puts for the most actively traded of the ETFs 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 the most actively traded ETF below, SPDR S&P 500 (NYSEARCA:SPY).

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

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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 SPY 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 SPY they cover, so that the total value of the 731 shares of SPY would be protected against a greater-than-20% decline.


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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.


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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 SPY 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 31.97 on Thursday. On June 23, when the VIX was at 19.29, the cost of hedging SPY against a greater-than-20% decline over the next six months was 1.40% of position value, as we noted in this article published the following day. As the screen shot below shows, on Thursday, the cost of hedging SPY against the same decline over about the same length of time as a percentage of position was 3.54%.


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Why There Were No Optimal Put Option Contracts for FAS and TZA

In some cases, the cost of protection may be greater than the loss you are looking to hedge against. That was the case with the Direxion Daily Financial Bull 3X ETF (NYSEARCA:FAS) and Direxion Russell 2000 3x Bearish ETF (NYSEARCA:TZA). As of Thursday, the cost of protecting against greater-than-20% declines in those ETFs 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 Thursday

The data in the table below is as of Thursday's close. The ETFs are listed in order of trading volume Thursday, with the most actively-traded name (SPY) at the top.

Symbol

Name

Cost of Protection (as % of position value)

SPY

SPDR S&P 500

3.54%**

XLF Financial Select Sector SPDR 8.36%**
QQQ PowerShares QQQ Trust 3.49%**
IWM iShares Russell 2000 Index 7.37%**
EEM iShares MSCI Emerging Index 5.58%**
FAS Direxion Daily Financial Bull 3X No Optimal Contracts
SDS UltraShort S&P 500 ProShares 11.7%**
EFA iShares MSCI EAFE Index 5.99**
XLI Industrial Select Sector SPDR 5.41%**
TZA Direxion Russell 2000 3x Bearish No Optimal Contracts
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*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.