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 |
| Business Software & Services | 2.34 | 2.19 | 0.52 | 1.85% | -1.95 | 2012 | ||
| Biotechnology | 42.86 | 5.63 | 4.29 | 5.14 | 3.41% | -0.04 | 2012 | |
| Internet Software & Services | 7.15 | 4.9 | 0.94 | 3.99% | 0.14 | 2012 | ||
| Electric Utilities | 0.99 | 1.66 | 1.26 | 3.03% | 0.24 | 2013 | ||
| Oil & Gas Pipelines | 55.24 | 2.46 | 5.76 | 3.38% | 0.49 | 2012 | ||
| Movie Production, Theaters | 66.54 | 0.78 | 8.4 | 0.67 | 3.22% | 0.57 | 2012 | |
| CATV Systems | 43.63 | 1.24 | 2.91 | 1.46 | 3.89% | 0.64 | 2014 | |
| Internet Service Providers | 21.15 | 0.67 | 0.98 | 0.93 | 3.39% | 0.68 | 2012 | |
| CATV Systems | 0.78 | 5.24 | 3.51% | 0.77 | 2012 | |||
| 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 |
| Diversified Communication Services | 0.45 | 6.84 | 1.78 | 2.31% | 0.81 | 2012 | ||
| Diversified Communication Services | 85.2 | 5.95 | 4.57 | 1.19 | 2.30% | 0.90 | 2014 | |
| Electric Utilities | 24 | 2.17 | 0.92 | 1.16 | 3.59% | 0.96 | 2012 | |
| Electric Utilities | 9.51 | 0.6 | 0.62 | 0.78 | 2.99% | 0.98 | 2012 | |
| Waste Management | 29.14 | 1.22 | 1.86 | 0.6 | 3.11% | 0.98 | 2012 | |
| Gas Utilities | 22.74 | 2.06 | 2 | 0.84 | 1.16% | 1.05 | 2012 | |
| Water Utilities | 21.95 | 4.15 | 2.56 | 0.2 | 2.11% | 1.16 | 2012 | |
| General Entertainment | 2.04 | 2.8 | 3.67% | 1.16 | 2012 | |||
| Restaurants | 0.74 | 1.01 | 0.97 | 3.50% | 1.26 | 2013 | ||
| Telecom Services - Domestic | 50.26 | 2.94 | 2.21 | 1.41 | 3.19% | 1.30 | 2013 | |
| Diversified Communication Services | 179.33 | 2.61 | 4.59 | 1.24 | 3.77% | 1.36 | 2012 | |
| Telecom Services - Domestic | 47 | 2.1 | 2.72 | 1.34 | 3.10% | 1.41 | 2012 | |
| REIT - Industrial | 22.2 | 1.51 | 1.97 | 1.48 | 3.53% | 1.48 | 2014 | |
| Gas Utilities | 21.66 | 0.97 | 2.26 | 0.46 | 1.47% | 1.57 | 2012 | |
| Paper & Paper Products | 51.32 | 0.88 | 3.58 | 2.15 | 0.27% | 1.61 | 2014 | |
| Entertainment - Diversified | 25.97 | 1.7 | 1.68 | 2.91% | 1.62 | 2013 | ||
| Oil & Gas Pipelines | 1.86 | 1.95 | 0.88 | 2.69% | 1.64 | 2013 | ||
| Business Software & Services | 29.58 | 1.99 | 3.63 | 0.84 | 2.65% | 1.65 | 2014 | |
| Independent Oil & Gas | 48.66 | 3.38 | 1.92 | 1.55 | 3.94% | 1.66 | 2014 | |
| REIT - Industrial | 31.78 | 5.02 | 4.66 | 1.01 | 2.42% | 1.68 | 2014 | |
| 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 | |
| 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.
