With other major stock indexes advancing Monday on news of a Franco-German commitment to shore up European banks, the Nasdaq Composite Index rose 3.50%, to close at 2,556.05. The Chicago Options Exchange Market Volatility Index dropped 8.78% to close at 33.02. The VIX has closed above 30 every day since the market meltdown of August 5th.
The table below shows the costs, as of Monday's close, of hedging 16 of the 20 most actively traded Nasdaq names against greater-than-20% declines over the next several months, using optimal puts.
For comparison purposes, I've also added the costs of hedging the SPDR S&P 500 Trust ETF (SPY) against a similar decline. The Nasdaq 100-tracking ETF PowerShares QQQ Trust ETF (QQQ) is also included, as it was on Nasdaq's most active list as of Tuesday. 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 stocks listed below, Microsoft Corporation (MSFT).
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 MSFT
Below is a screen capture showing the optimal put option contract to buy to hedge 100 shares of MSFT against a greater-than-20% drop between now and May 18, 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 increased, so have hedging costs. As we mentioned above, the VIX volatility index closed at 33.02 on Monday. On July 13th, when the VIX closed at 19.91, the cost of hedging MSFT against a a greater-than-20% drop over the next 6 months was 2.37% of position value, as we noted in this article published the following day. As you can see in the screen capture below, the cost of the same level of protection on MSFT over approximately the same length of time was 4.19% as of Monday.
Why There Were No Optimal Contracts For 4 Of These Stocks
In some cases, the cost of protection may be greater than the loss you are looking to hedge against. That was the case with four of the stocks listed below. As of Monday, the cost of protecting against greater-than-20% declines in those stocks 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 Monday's Close
Aside from the SPY, listed at the bottom for comparison purposes, the names are listed in order of their share volume in Monday's trading, with the most actively traded name, Cisco Systems (CSCO), listed first.
Cost of Protection (as % of position value)
|(QQQ)||PowerShares QQQ Trust ETF||3.50%*|
|(MU)||Micron Technologies Inc.||No Optimal Contracts|
|(NFLX) ||Netflix Inc. ||No Optimal Contracts|
|(RIMM)||Research in Motion Limited||15.9%*|
|(HBAN)||Huntington Bank Shares Inc.||No Optimal Contracts|
|(AMAT)||Applied Materials, Inc.||8.36%**|
|(FITB)||Fifth Third Bancorp||18.3%***|
|(MPEL)||Melco Crown Entertainment Ltd.||No Optimal Contracts|
|(GLBL)||Global Industries, Ltd.||5.12%**|
SPDR S&P 500
*Based on optimal puts expiring in March 2012.
**Based on optimal puts expiring in April 2012.
***Based on optimal puts expiring in May 2012.