An Update On Dow Component Hedging Costs

|
 |  Includes: AA, AXP, BA, BAC, CAT, CSCO, CVX, DD, DIA, DIS, GE, HD, HPQ, IBM, INTC, JNJ, KO, MCD, MDLZ, MMM, MRK, MSFT, PFE, PG, T, TRV, UTX, VZ, WMT, XOM
by: David Pinsen

An Up Day After The Worst Week Since October 2008

The Dow Jones Industrial Average gained 272.38 points, or 2.53% on Monday, after dropping 738 points, or 6.4% last week - the Dow's worst weekly performance since October, 2008. The Chicago Board Options Exchange Market Volatility Index (VIX) ended last week at 41.25, after spiking as high as 43.73 on Thursday, which was its highest level in over a month. The costs of hedging the SPDR Dow Jones Industrial Average ETF (NYSEARCA:DIA) and most of the Dow component stocks rose significantly on the week.

Hedging the Dow

The table below shows the costs, as of Friday's close, of hedging 29 of the 30 Dow components, and the SPDR Dow Jones Industrial Average 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 why I've used 20% as a decline threshold here; then, a screen capture showing the optimal puts for one of the Dow components listed below, Wal-Mart Stores, Inc. (NYSE:WMT).

About Optimal Puts

Optimal puts are the ones that will give you the level of protection you want at the lowest possible cost. Portfolio Armor 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.

Decline Thresholds

"Decline Threshold" is the maximum decline you are willing to risk in the value of your position in a security. You can enter any percentage you like for a decline threshold when scanning for optimal puts (the higher the percentage though, the greater the chance you will find optimal puts for your position). I have used 20% thresholds for each of the securities below. 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 WMT

Here is a screen shot showing the optimal puts for one of the Dow components listed below, WMT. This shows the optimal put option contracts to buy to hedge 100 shares of WMT against a greater-than-20% drop between now and March, 16, 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. On Tuesday, July 13, when the VIX was at 19.91, the cost of hedging WMT against a greater-than-20% decline over the next six months was 0.94% of position value, as we noted in this post published the following day. As the screen shot below shows, on Friday, the cost of hedging WMT against the same decline over about the same time frame was 2.34%.

Click to enlarge

Why There Were No Optimal Contracts 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)

(NYSE:AA)

Alcoa Inc. Common Stock

16.2%***

(NYSE:AXP)

American Express

9.26%***

(NYSE:BA)

Boeing

6.47%*

(NYSE:BAC)

Bank of America

No Optimal Contracts

(NYSE:CAT)

Caterpillar

11.4%*

(NASDAQ:CSCO)

Cisco Systems

7.88%***

(NYSE:CVX)

Chevron

6.72%**

(NYSE:DD)

E.I. du Pont de Nemours

10.4%***

(NYSE:DIS)

Walt Disney

7.91%***

(NYSE:GE)

General Electric

8.88%**

(NYSE:HD)

Home Depot

4.48%*

(NYSE:HPQ)

Hewlett-Packard

8.74%*

(NYSE:IBM)

International Business Machines

4.52%***

(NASDAQ:INTC)

Intel

7.22%***

(NYSE:JNJ)

Johnson & Johnson

4.38%***

(NYSE:JPM)

JP Morgan Chase

12.8%**

(KFT)

Kraft Foods

2.49%**

(NYSE:KO)

Coca-Cola

2.30%*

(NYSE:MCD)

McDonald's

2.84%**

(NYSE:MMM)

3M

6.35%***

(NYSE:MRK)

Merck

5.22%***

(NASDAQ:MSFT)

Microsoft

5.91%***

(NYSE:PFE)

Pfizer

4.81%**

(NYSE:PG)

Procter & Gamble

3.89%***

(NYSE:T)

AT&T

4.81%***

(NYSE:TRV)

Travelers

9.55%***

(NYSE:UTX)

United Technologies

5.80%*

(NYSE:VZ)

Verizon Communications

4.46%***

(WMT)

Wal-Mart Stores

2.34%**

(NYSE:XOM)

Exxon Mobil

5.99%***

(DIA)

SPDR Dow Jones Industrial Average ETF

4.89%**

Click to enlarge

*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.

Additional disclosure: I am long puts on DIA.