Some Potential Winners
In a Seeking Alpha article on Thursday ("11 Infrastructure Stocks to Watch"), Alex B. Gray listed 11 stocks that were positioned to benefit from future infrastructure stimulus spending if parts of President Obama's jobs plan gets enacted. The table below shows the costs, as of Friday's close, of hedging 6 of them against greater-than-20% declines over the next several months, using optimal puts.
Some Potential Losers
In a post on IndexUniverse.com on September 8th ("ETFs for the Obama Jobs Plan"), Paul Baiocchi noted that, if the President has his way, stimulus legislation could also include tax penalties on domestic energy companies:
Should this come to pass, the restructuring of treatment of foreign taxes paid or depletion allowances for U.S. energy giants Chevron (CVX), Exxon (XOM) and Chesapeake (CHK) could result in downward revisions to growth and profit estimates. If such changes come to pass, protection-in the form of sell stops or some other hedge-should be put in place on funds like the Energy Select Sector SPDR (XLE) and the iShares Dow Jones US Energy Sector (IYE).
With that in mind, I've included the costs of hedging those energy stocks and ETFs against greater-than-20% declines over the next several months in the table below as well. Incidentally, whether the Obama administration's policy of favoring green energy over conventional energy sources is effective at creating jobs and economic growth has been the subject of lively debate. In a Politico piece on Friday ("The Crisis of the 'Gentry Presidency'"), Joel Kotkin suggested otherwise:
Fossil-fuel development, for example, represents one of the best opportunities for new, high-wage employment for blue- and white-collar workers. In contrast, the massive expenditures of public money on “green jobs” has turned out to be less than effective in creating blue-collar employment.
For comparison purposes, I've also added the costs of hedging the SPDR S&P 500 Trust ETF (NYSEARCA:SPY) against the same greater-than-20% decline with optimal puts. First, a reminder about what optimal puts mean in this context, and why I've used 20% as a decline threshold here; then, a step by step example of finding optimal puts for one of the stocks listed below, Home Depot, Inc. (HD).
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 to sort through and analyze all of the available puts for your position, scanning for the optimal ones.Decline Thresholds
You can enter any percentage you like for a threshold (the higher the percentage though, the greater the chance you will find optimal puts for your position). Essentially, 20% is a large enough threshold that it reduces the cost of hedging but not so large that it precludes a recovery.
The Optimal Puts for Home Depot, Inc.
Here is a screen shot showing the optimal puts for one of the stocks listed below, Home Depot, Inc. This shows the optimal put option contracts to buy to hedge 100 shares of HD against a greater-than-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. The VIX closed at 30.98 on Friday, September 16. On Thursday, May 19, when the VIX was at 15.52, the cost of hedging HD against a greater-than-20% decline over the next six months was 1.74% of position value, as we noted in this article published the following day. As the screen shot below shows, on Friday, the cost of hedging HD against the same decline over a shorter time frame (5 months), as a percentage of position, was 3.21%.
The data in the table below is as of Friday's close.
Cost of Protection (as % of position value)
SPDR S&P 500
|GVA||Granite Construction Inc.||12.0%**|
|HD||Home Depot, Inc.||3.21%*|
|LOW||Lowe's Companies, Inc.||6.43%***|
|MLM||Martin Marietta Materials, Inc.||7.47%***|
|SHW||The Sherwin-Williams Company||3.65%**|
|VMC||Vulcan Materials Company||9.04%*|
|IYE||iShares Dow Jones US Energy||7.38%***|
|IYE||iShares Dow Jones US Energy||7.38%***|
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.