On Wednesday, a day when the Nasdaq Composite declined nearly 1%, several Nasdaq stocks rose on unusual volume -- six of them rose on increases in their daily volumes of more than 100%. The table below shows the costs, as of Wednesday's close, of hedging those six stocks against greater-than-23% declines over the next several months, using optimal puts.
For comparison purposes, I've also added the costs of hedging the SPDR S&P 500 Trust ETF (NYSEARCA:SPY) and the Nasdaq 100-tracking ETF PowerShares QQQ Trust ETF (NASDAQ:QQQ). First, a reminder about what optimal puts are, plus a note about why I've used 23% as a decline threshold here. Then, a screen capture showing the optimal puts for one of the six stocks, Cintas Corporation (NASDAQ:CTAS).
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.
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 20% decline threshold when hedging equities, but two of these stocks, Research In Motion Limited (RIMM) and Mitcham Industries Inc. (MIND), were too expensive to hedge using a 20% threshold (i.e., the cost of hedging them against a 20% decline was itself more than 20% of position value, so Portfolio Armor indicated there were no optimal contracts available for them). There were optimal contracts for all of these stocks against a 23% threshold, so that's the decline threshold I've used here.
The Optimal Puts For CTAS
Below is a screen capture showing the optimal put option contract to buy to hedge 100 shares of Cintas against a greater-than-23% drop between now and May 18, 2012. A note about these optimal put options and their cost: To be conservative, we 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 Wednesday's Close
Aside from the ETFs listed at the bottom for comparison purposes, the stocks below are listed in order of volume change Wednesday, with the one with the most unusually high volume, Shuffle, Inc. (SHFL), listed first. Hedging costs are presented as percentages of position value. Regarding the stocks below with the highest hedging costs, Research In Motion and Mitcham Industries, recall a previous article ("High Optimal Hedging Costs: A Red Flag?") where we speculated that high hedging costs could presage future underperformace.
|RIMM||Research In Motion Limited||22.5%**|
|MIND||Mitcham Industries Inc.||21.8%**|
|DRIV||Digitial River, Inc.||9.13%**|
|VRA||Vera Bradley, Inc.||15.4%*|
SPDR S&P 500
|QQQ||PowerShares QQQ Trust||2.01%**|
*Based on optimal puts expiring in May, 2012
**Based on optimal puts expiring in June, 2012
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.