Hedging Against A 4,000 Point Drop In The Dow

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|  Includes: DIA, GLD, IAU, LQD, TLT
by: David Pinsen

Predicting a 4,000 Point Drop in the Dow

On Bloomberg Television last Monday, veteran technical analyst Joseph Granville offered a decidedly bearish outlook for the rest of 2012: he predicted a 4,000 point drop in the Dow. Granville based his prediction on trends in momentum, price, and volume, arguing in particular that a drop off in trading volume presaged a market decline. In this post, we'll look at a way to hedge a \$500,000 stock portfolio against a 4,000 point drop in the Dow by buying optimal puts on the ETF that tracks it, the SPDR Dow Jones Industrial Average (NYSEARCA:DIA).

Comparisons

For comparison purposes, I've added a table showing the costs of hedging a portfolio invested in other asset classes -- Treasury bonds, corporate bonds, and gold -- against the same percentage decline, using ETFs that track those asset classes. First, a reminder about what optimal puts are, and an explanation about the decline threshold we'll be using; then, a screen capture showing the optimal puts on DIA to hedge a \$500,000 stock portfolio against a 4,000 point drop in the Dow.

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 downside 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). Here, we'll use a percentage decline based on Granville's prediction of a 4,000 point drop in the Dow.

Since the Dow closed at 12,660.46 on Friday, a 4,000 point drop would represent a 31.6% drop in percentage terms [(4,000 / 12,660.46) x 100%]. So we'll use a 31% decline threshold here, because that's the lowest we're willing to see our position drop in this case -- we want to be hedged against a 31.6% drop.

The Optimal Puts to Hedge Against a 31.6% Drop in the Dow

Below is a screen capture showing the optimal put option contracts to buy to hedge a \$500,000 portfolio against a greater-than-31% drop in the Dow between now and June 15th. Because we're using DIA as a proxy, we've entered 3,954 in the "shares owned" field, since \$500,000 represents that many shares of DIA at DIA's closing price of \$126.45 on Friday (\$500,000 / \$126.45 = 3,954).

Two notes 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 (the same is true for the rest of the names below).
• In this case, Portfolio Armor's algorithm rounded down the number of shares we entered to the nearest hundred (since one put option contract represents the right to sell one hundred shares of the underlying security), and then presented us with 39 of the put option contracts that would slightly over-hedge the 3,900 shares they cover, so that the total value of our 3,954 shares would be protected against a greater-than-31% loss.

Rolling Protection

In his Bloomberg appearance, Joseph Granville said it might take all four quarters of this year for the Dow to shed 4,000 points. Note that optimal puts in the screen capture above expire on June 15th, so they wouldn't provide protection for the full year. You'd need to buy new optimal puts before they expired, if you wanted to continue to insure your portfolio. In some cases, you can reduce the total cost of your insurance by selling your puts when they still have some time value left, and using the proceeds of the sale to offset the cost of the new puts you buy (i.e., "rolling" your puts). We are working on a tool to identify the best time to roll puts.

Hedging other Asset Classes Against 31% Declines

The hedging data in the table below is as of Friday's close, and is presented as percentages of position values. These costs were calculated using round lots of shares in the underlying ETFs, so you'll notice a slight (1 basis point) difference in the cost of hedging DIA in the table below versus in the screen capture above. Note that the costs of hedging are fairly low for all for all of these asset classes now. If you are concerned about downside risk, you may want to consider hedging now, while it's inexpensive to do so.

 Symbol Name Hedging Cost Stocks DIA SPDR DJIA 0.36%* Treasury Bonds TLT iShares Barclays 20+ Year 0.17%* Corporate Bonds LQD iShares iBoxx Invest Grade 0.30%* Gold GLD SPDR Gold Shares 0.22%* IAU iShares Gold Trust 0.59%**
Click to enlarge

*Based on optimal puts expiring in June

**Based on optimal puts expiring in July

Disclosure: I may purchase optimal puts on DIA next week.