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Investing in the stock market is treacherous because there are occasional price declines that demolish shareholder value. Investors can hedge their exposure to financial turmoil by purchasing deep out of the money put options on stocks. A list of stocks which - (1) score as potentially distressed according to the Altman Z-Score, (2) have long-dated put option markets, and (3) have lower than average volatility for their Altman Z-Score rating - can be found below.

Deep out of the Money Put Options as Portfolio Insurance

Deep out of the money put options have no intrinsic value and will expire worthless unless there is a dramatic price decline in a stock. Thus, they tend to be somewhat inexpensive but are unlikely to provide any return. Put buyers must carefully select stocks which score poorly according to tests of financial health since the vast majority of out-of-the-money puts expire worthless.

Fortunately, there are ways to assign risk to stocks based on market data and fundamental data. One measure of credit scoring can be provided by the volatility of a stock’s price. Essentially, the more volatile the stock is, the more likely the possibility of its price moving dramatically. Unfortunately, volatility is a major determinant in the pricing of options, so this metric alone wouldn’t help identify bargain puts. In short: buying puts on higher volatility stocks would cost more.

The Altman Z-Score as a Forecast of Future Financial Hardship

The Altman Z-Score is a measure of bankruptcy risk that is not based on stock price volatility. This score places companies into three groups: “safe” (Z-score > 2.99), “grey” (Z-score between 2.99 and 1.81), and “distressed*” (Z-score < 1.81), and is surprisingly useful for identifying bankruptcy risk in the coming year. This method of segmenting companies is based on fundamental (financial statement) data and market capitalization only, not on price volatility.** Beyond credit risk prediction, companies with higher Z-scores have historically outperformed companies with lower Z-scores, in aggregate. One sector has not been accurately modeled: Altman’s Z-score has not accurately predicted the bankruptcy risk of financial companies.

Generating a List of Deep out of the Money Put Candidates

Altman Z-Scores were calculated for stocks with options markets and price to earnings ratios greater than 20. These stocks fell into three risk categories:

Altman Z-Score Category

Category Z-Score Bounds

Average Monthly Volatility

Distressed

Less than 1.81

5.08%

Grey Zone

1.81 to 2.99

4.81%

Safe

2.99 and Higher

4.64%

As you can see there is an inverse relationship between volatility and Z-score which confirms that in aggregate higher volatility (and put prices) go up as credit scores deteriorate. Thankfully, the relationship is very weak (R-Squared value of less than 0.01) so there is considerable opportunity to try to pick and choose puts that provide the most insurance for your dollar.

Here is a list of stocks which score as “distressed” with monthly volatilities below 4%:

Ticker

Industry

P/E

P/S

P/B

Beta

Volatility (Monthly)

Altman Z-Score

Latest Option Expiration

SONE

Business Software & Services

2.34

2.19

0.52

1.85%

-1.95

2012

VNDA

Biotechnology

42.86

5.63

4.29

5.14

3.41%

-0.04

2012

ARBA

Internet Software & Services

7.15

4.9

0.94

3.99%

0.14

2012

CPN

Electric Utilities

0.99

1.66

1.26

3.03%

0.24

2013

KMI

Oil & Gas Pipelines

55.24

2.46

5.76

3.38%

0.49

2012

LGF

Movie Production, Theaters

66.54

0.78

8.4

0.67

3.22%

0.57

2012

LBTYA

CATV Systems

43.63

1.24

2.91

1.46

3.89%

0.64

2014

ELNK

Internet Service Providers

21.15

0.67

0.98

0.93

3.39%

0.68

2012

CHTR

CATV Systems

0.78

5.24

3.51%

0.77

2012

INXN

Internet Information Providers

22.32

2.67

1.99

3.67%

0.77

2012

EP

Oil & Gas Pipelines

35.54

4.33

3.53

1.41

2.42%

0.78

2014

PAET

Diversified Communication Services

0.45

6.84

1.78

2.31%

0.81

2012

CCI

Diversified Communication Services

85.2

5.95

4.57

1.19

2.30%

0.90

2014

ORA

Electric Utilities

24

2.17

0.92

1.16

3.59%

0.96

2012

NRG

Electric Utilities

9.51

0.6

0.62

0.78

2.99%

0.98

2012

CVA

Waste Management

29.14

1.22

1.86

0.6

3.11%

0.98

2012

SUG

Gas Utilities

22.74

2.06

2

0.84

1.16%

1.05

2012

WTR

Water Utilities

21.95

4.15

2.56

0.2

2.11%

1.16

2012

SIX

General Entertainment

2.04

2.8

3.67%

1.16

2012

WEN

Restaurants

0.74

1.01

0.97

3.50%

1.26

2013

EQIX

Telecom Services - Domestic

50.26

2.94

2.21

1.41

3.19%

1.30

2013

CCOI

Diversified Communication Services

179.33

2.61

4.59

1.24

3.77%

1.36

2012

TWTC

Telecom Services - Domestic

47

2.1

2.72

1.34

3.10%

1.41

2012

WY

REIT - Industrial

22.2

1.51

1.97

1.48

3.53%

1.48

2014

GAS

Gas Utilities

21.66

0.97

2.26

0.46

1.47%

1.57

2012

TIN

Paper & Paper Products

51.32

0.88

3.58

2.15

0.27%

1.61

2014

MSG

Entertainment - Diversified

25.97

1.7

1.68

2.91%

1.62

2013

CPNO

Oil & Gas Pipelines

1.86

1.95

0.88

2.69%

1.64

2013

IRM

Business Software & Services

29.58

1.99

3.63

0.84

2.65%

1.65

2014

APC

Independent Oil & Gas

48.66

3.38

1.92

1.55

3.94%

1.66

2014

PCL

REIT - Industrial

31.78

5.02

4.66

1.01

2.42%

1.68

2014

RGC

Movie Production, Theaters

45.41

0.82

0.96

2.96%

1.72

2012

HEK

Diversified Investments

7.33

2.24

0.78

2.43%

1.72

2012

RNWK

Application Software

39

0.9

0.79

1.35

3.50%

1.81

2012

It is prudent to note that there is no way to tell the future, and that many of these firms are currently healthy and will remain so in the future. This is a list of put candidates based on a credit scoring model, and by no means is a divination or a guarantee about future events.

*“Distressed” was a label coined by researchers, and should not be taken to mean that any company is bankrupt or in default on the basis of this calculation alone. Credit scoring is not fate, only prediction based on relative past performance of companies grouped by key variables. Time will tell.

**Volatility has been incorporated into a credit scoring to improve accuracy and extend it to financial companies, but this would reduce the value of a fundamentals-only model for indicating attractively-priced put options.

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

Source: Put Options To Consider For Portfolio Insurance