On Monday, a day when the Nasdaq Composite declined fractionally, several Nasdaq stocks rose on unusual volume -- six of them rose on increases in their daily volumes of more than 100%. Of those six, one of them, MGE Energy, Inc. (NASDAQ:MGEE), didn't have options traded on it. The table below shows the costs, as of Monday's close, of hedging the other five stocks against greater-than-24% declines over the next several months, using optimal puts.
For comparison purposes, I've also added the costs of hedging the SPDR S&P MidCap 400 ETF (NYSEARCA:MDY) and the Nasdaq 100-tracking ETF PowerShares QQQ Trust ETF (NASDAQ:QQQ). First, a reminder about what optimal puts are, and a note about why I've used 24% as a decline threshold here; then, a screen capture showing the optimal puts for the most expensive of these stocks to hedge, Ubiquiti Networks, Inc. (NASDAQ:UBNT).
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 one of these stocks, Ubiquiti Networks, Inc. , 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 names against a 24% threshold, so that's the decline threshold I've used here.
The Optimal Puts For UBNT
Below is a screen capture showing the optimal put option contract to buy to hedge 100 shares of Ubiquiti Networks, Inc. against a greater-than-24% drop between now and June 15. 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 slightly lower price, i.e., some price between the bid and the ask (the same is true of the other names in the table below). Still, the hedging cost here is extremely high: as a percentage of position, it's more than 30 times the cost of hedging the comparison ETF QQQ. Recall that we've observed examples where high optimal hedging costs presaged poor performance.
Hedging Costs As Of Monday'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, Amlyn Pharmaceuticals, Inc. (AMLN), listed first. Hedging costs are presented as percentages of position value.
|AMLN||Amlyn Pharmaceuticals, Inc.||12.6%**|
|UBNT||Ubiquiti Networks, Inc.||23.8%*|
SPDR S&P MidCap 400
|QQQ||PowerShares QQQ Trust||0.78%*|
*Based on optimal puts expiring in June
**Based on optimal puts expiring in July