ETF Hedging Costs Spike From Q2 To Q3

What a difference a quarter makes

In a few articles during the second quarter (such as this one), I mentioned a couple of reasons why investors might have wanted to consider hedging their stocks then:

1. With stock market volatility declining recently [...] it has gotten cheaper to hedge. [...]
2. Prudence may be warranted with the end of the second round of the Fed’s quantitative easing (QE2) scheduled for the end of June. On Bloomberg TV [...] economist David Rosenberg (formerly, Merrill Lynch’s chief North American economist) noted that there’d been an 88% correlation between the movements in the Fed balance sheet and the direction of the S&P 500 over the last two years.

What a difference a quarter makes. At the end of the second quarter, the S&P 500 Volatility Index (VIX) closed at 16.52; at the end of the third quarter, on Friday, the VIX closed at 42.96. David Rosenberg's warning also proved prescient, as the S&P 500 declined 14.3% during the 3rd quarter.

Hedging costs of Leading ETFs -- then and now

The two tables below show how hedging costs have spiked over the third quarter for a basket of ten widely traded ETFs. The first table shows costs as, as of June 23rd, of hedging each ETF against greater-than-20% declines over the next several months, using optimal puts. The second table shows the costs of hedging the same ETFs against the same decline threshold over the next several months, as of September 30th. First, a reminder about what optimal puts are, and why I've used 20% as a decline threshold; then, a screen capture showing the current optimal puts to hedge one of the ETFs listed below, Health Care Select SPDR (XLV).

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

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 XLV

Below is a screen capture showing the optimal put option contract to buy to hedge 100 shares of XLV against a greater-than-20% drop between now and March, 16, 2012. One note 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.

(Click to enlarge)

Hedging Costs as of Thursday, June 23rd

The data in the table below are as of June 23rd, and originally appeared in this article published on June 24th. The ETFs are listed in order of their trading volume on June 23rd, with the most heavily-traded ETF (SPY) at the top.

Symbol	Name	Cost of Protection (as % of position value)
SPY	SPDR S&P 500	1.40%*
XLF	Financial Select Sector SPDR	3.10%*
IWM	iShares Russell Index 2000	2.69%*
EEM	iShares MSCI Emerging Markets	2.59%*
XLE	Energy Select Sector SPDR	2.24%*
USO	The United States Oil ETF, LP	4.47%**
EWJ	iShares MSCI Japan Index	2.58%*
XLI	Industrial Select Sector SPDR	2.22%*
EFA	iShares MSCI EAFE Index	3.07%*
XLV	Health Care Select SPDR	1.14%*

*Based on optimal puts expiring in December, 2011

*Based on optimal puts expiring in January, 2012

Hedging Costs as of Friday, September 30th

The data in the table below are as of Friday, September 30th. For comparison purposes, the ETFs are listed in the same order as in the table above.

Symbol	Name	Cost of Protection (as % of position value)
SPY	SPDR S&P 500	4.69%*
XLF	Financial Select Sector SPDR	10.1%*
IWM	iShares Russell Index 2000	8.21%*
EEM	iShares MSCI Emerging Markets	9.54%*
XLE	Energy Select Sector SPDR	9.66%*
USO	The United States Oil ETF, LP	8.07%*
EWJ	iShares MSCI Japan Index	3.17%*
XLI	Industrial Select Sector SPDR	7.15%*
EFA	iShares MSCI EAFE Index	9.42%*
XLV	Health Care Select SPDR	3.94%*

*Based on optimal puts expiring in March, 2012

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.