8 'Buy' Rated Electric Utilities And Their Hedging Costs

 |  Includes: CMS, DUK, FE, GXP, SCG, SO, WR, XLU
by: David Pinsen

In a recent article ("Hedging 10 High 'Value, Safety, Timing ['VST']' Stocks"), we described VectorVest's master ranking system, which consists of a weighted average of its scores for Relative Safety (RS), Relative Timing (RT), and Relative Value (RV), with RT overweighted and RV underweighted. VectorVest uses that master "VST" master ranking in assigning "buy", "hold", and "sell" rankings to stocks. The electric utility stocks in the table below were all rated "buy" by VectorVest on Wednesday.

Hedging Costs of buy-rated electric utilities

I also looked at the costs of hedging these utility stocks against greater-than-20% declines over the next several months, using optimal puts. You can see those costs in the table below, along with the costs of hedging the Utilities Select Sector SPDR ETF (NYSEARCA:XLU), for comparison purposes. 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 utilities listed below, Southern Company (SO).

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 SO

Below is a screen capture showing the optimal put option contract to buy to hedge 100 shares of SO against a greater-than-20% drop between now and May 18, 2012. A 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.

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Hedging Costs As Of Wednesday's Close

Aside from the ETF XLU, listed at the bottom for comparison purposes, the utility stocks are listed in order of their 50-day moving average volume, with the most actively traded utility, Duke Energy (NYSE:DUK), listed first.



Cost of Protection (as % of position value)

(DUK) Duke Energy 2.27%**
(NYSE:SO) Southern Company 1.90%***
(NYSE:CMS) CMS Energy Corp. 3.49%*
(NYSE:FE) FirstEnergy Corp. 3.22%**
(NYSE:PGN) Progress Energy Inc. 5.18%**
(NYSE:GXP) Great Plains Energy Inc. 3.76%*
(NYSE:WR) Westar Energy, Inc. 3.01%*
(NYSE:SCG) SCANA Corp. 4.31%***
(XLU) Utilities Select Sector SPDR 2.05%*
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*Based on optimal puts expiring in March 2012.
**Based on optimal puts expiring in April 2012.
***Based on optimal puts expiring in May 2012.

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