Relative Safety is a measure of risk VectorVest calculates based on its analysis of:
the consistency and predictability of a company's financial performance, debt to equity ratio, sales volume, business longevity, price volatility and other factors.
VectorVest ranks stocks in terms of Relative Safety on a scale from 0 to 2, with 2 being the highest (best) possible score. The stocks listed in the table below had the ten highest Relative Safety scores in VectorVest's universe of US-traded stocks on Friday, with scores ranging from 1.47 to 1.50. I was interested in seeing what the hedging costs of these "relatively safe" stocks were, so I calculated them in the table using optimal puts (surprisingly, the costs were pretty high, even considering the current high level of market volatility). First, a reminder about what optimal puts are, and why I've used 20% as a decline threshold; then, a screen capture shows the current optimal puts to hedge one of the stocks listed below, Chevron Corporation (CVX).
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.
In this context, "threshold" refers to 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 CVX
Below is a screen capture showing the optimal put option contract to buy to hedge 100 shares of CVX 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 CVX against a greater-than-20% decline over the next six months was 2.58% of position value, as we noted in this post published the following day. As the screen shot below shows, on Friday, when the VIX closed at 42.96, the cost of hedging CVX against the same decline over about the same time frame was 5.83%.
Why There Were no Optimal Contracts for INT
In some cases, the cost of protection may be greater than the loss you are looking to hedge against. That was the case with World Fuel Services Corporation (INT). As of Friday, the cost of protecting against a greater-than-20% decline in that stock 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, September 30th The data in the table below are as of Friday, September 30th. The stocks are listed in order of Relative Safety, with VectorVest's highest scoring Relative Safety stock (Church & Dwight) listed first.
Cost of Protection (as % of position value)
Church & Dwight Co. Inc.
World Fuel Services Corp.
No Optimal Contracts
|(NASDAQ:TSCO)||iShares MSCI Emerging Markets||12.0%**|
|(HANS)||Hansen Natural Corporation||10.2%*|
|(NYSE:PCP)||Precision Castparts Corp.||8.36%*|
|(NASDAQ:FCFS)||First Cash Financial||10.3%*|
*Based on optimal puts expiring in March, 2012
**Based on optimal puts expiring in April 2012
***Based on optimal puts expiring in May 2012