Hedging 6 Stocks Benefiting From The Bifurcation In Retail

by: David Pinsen

Discount stores and the bifurcation in retail

Back in January, S&P Equity Research analysts identified ten trends they expected to continue in 2011, one of which was the bifurcation in retail:

We expect continued bifurcation of the retail market with high-end luxury stores benefiting from the wealth effect and low-end stores being aided by value-seeking consumers.

Relative Timing and low-end retail

Recall that in a recent article ("Hedging 10 High 'Relative Timing' Stocks") we described VectorVest's Relative Timing indicator, which is a measure of technical strength. In addition to applying that to stocks, VectorVest also applies it to industry groups, by aggregating the data for the stocks within each industry group. VectorVest breaks retail into 15 different industry groups; unfortunately, none of those industry groups carves out luxury retail stores, but one does carve out low-end retail stores, the "Discount/Variety" industry group. On Monday, that industry group had the highest Relative Timing in VectorVest's universe, consistent with S&P Equity Research's prediction about the continued bifurcation of retail.

Hedging costs of 6 stocks benefiting from the bifurcation

The "Discount/Variety" industry group includes 8 stocks, 6 of which are up year-to-date, and are also "Buy"-rated by VectorVest. The table below shows the costs, as of Monday's close, of hedging those 6 stocks against greater-than-20% declines over the next several months, using optimal puts, along with the costs of hedging the Retail HOLDRs ETF (RTH), 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 showing the current optimal puts to hedge one of the low-end retail stocks listed below, 99 Cents Only Stores (NDN).

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 NDN

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

(Click to enlarge)

Hedging Costs As Of Monday's Close

Aside from the ETF RTH, listed at the bottom for comparison purposes, the retail stocks below are listed in order of their VectorVest 'VST' (Value, Safety, Timing) ranking, with the highest-ranked stock in the industry group, Dollar Tree, Inc. (DLTR), listed first.



Cost of Protection (as % of position value)

(DLTR) Dollar Tree, Inc. 4.01%***
(PSMT) PriceSmart, Inc.
(FDO) Family Dollar Stores, Inc. 4.61%**
(NDN) 99 Cents Only Stores
(DG) Dollar General Corporation 5.34%***
(BIG) Big Lots, Inc. 8.13%**
(RTH) Retail HOLDRs 4.60%**

*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.