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Hedging the 6 highest rated desktop software stocks

In a recent article ("Hedging 6 of the Highest-Rated Computer Companies"), we looked at hedging 6 of the computer makers that had the highest VST rankings from VectorVest. Recall that VST (Value, Safety, Timing), VectorVest's master ranking, is made up of a weighted average of its Relative Value, Relative Safety and Relative Timing indicators, with Relative Value underweighted and Relative Timing overweighted. This time, we'll look at hedging the 6 highest rated software companies in VectorVest's desktop software industry category (Desktop is one of 5 industry sub-categories VectorVest breaks the broader software category into). The table below shows the VST ratings, as well as the costs, as of Monday's close, of hedging these stocks against greater-than-31% declines over the next several months, using optimal puts.

A Comparison

For comparison purposes, I've also added the cost of hedging the Nasdaq 100-tracking ETF PowerShares QQQ Trust ETF (QQQ). First, a reminder about what optimal puts are, plus a note about why I've used 31% as a decline threshold here; then, a screen capture showing the optimal puts for one of the 6 software stocks, Nuance Communications (NUAN).

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" is the maximum decline you are willing to risk. 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). Usually, I use a 20% decline threshold when hedging, but one of these stocks, LogMein, Inc. (LOGM) was too expensive to hedge using a 20% threshold (i.e., the cost of hedging it against a 20% decline was itself more than 20% of position value, so Portfolio Armor indicated there were no optimal contracts available for it). There were optimal contracts for all of these stocks against a 31% threshold, so that's the decline threshold I've used here.

The Optimal Puts For NUAN

Below is a screen capture showing the optimal put option contract to buy to hedge 100 shares of NUAN against a greater-than-31% drop between now and April 20, 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.

Hedging Costs As Of Monday's Close

The names below are listed in order of their VectorVest VST (Value, Safety, Timing) ranking. Hedging costs are presented as percentages of position value. Of the software stocks below, Adobe Systems Inc. (ADBE) and Microsoft Corp. (MSFT) are rated "hold"; the other four are rated "buy".

Symbol

Name

VST

Hedging Cost

NUAN Nuance Communications 1.36 3.19%*
LOGM LogMein, Inc. 1.19 14.1%***
RHT Red Hat, Inc. 1.18 9.48%***
ADBE Adobe Systems, Inc. 1.17 2.14%*
TYPE Monotype Imaging 1.14 11.0%**
MSFT Microsoft Corp. 1.11 1.17%*
QQQ PowerShares QQQ Trust 1.03 2.08%***

*Based on optimal puts expiring in April, 2012

**Based on optimal puts expiring in May, 2012

***Based on optimal puts expiring in June, 2012

Source: Hedging The 6 Highest Rated Desktop Software Stocks