In his recent Forbes column ("Hit the refresh button"), Ken Fisher recapped the performance of his 2011 stock picks before presenting five new picks for 2012. According to Fisher, his best performing pick last year was Bristol Myers Squibb (NYSE:BMY), which was up 44% since recommended it last February, and his worst performing pick was Aixtron Aktiengesellschaft (NASDAQ:AIXG), which had dropped 63% since he recommended it last July. Fisher apparently is still bullish on AIXG, as he suggested investors who bought his 2011 picks hold onto all of them for 2012. A thought occurred to me while reading that: if an investor had hedged AIXG against, say, a greater-than-20% drop when he purchased it in late July, he might have been able to sell his appreciated puts after the stock had dropped nearly two thirds, and use the proceeds to buy more of the stock at a lower price.
At this point, though, AIXG is too expensive to hedge against a greater-than-20% decline using optimal puts: the cost of hedging it against one would itself be greater than 20% of position value, so our algorithm indicated that no optimal puts were found for it. It is possible to hedge Fisher's best-performing pick from last year -- Bristol Myers Squibb -- and his five new picks for this year against greater-than-20% declines though. The table below shows the costs, as of Friday's close, of hedging those 6 stocks against greater-than-20% declines over the next several months, using optimal puts.
For comparison purposes, I've added the SPDR Select Sector Fund -- Industrials ETF (NYSEARCA:XLF) and the SPDR S&P 500 Trust ETF (NYSEARCA:SPY) to the table. First, a reminder about what optimal puts are, and a note about decline thresholds. Then, a screen capture showing the optimal puts to hedge one of the stocks below, Baxter International, Inc. (BAX).
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" refers to the maximum decline 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). I have used 20% decline thresholds for all of the names here.
The Optimal Puts for BAX
Below is a screen capture showing the optimal put option contract to buy to hedge 100 shares of Baxter International against a greater-than-20% decline between now and August 17th. A note about these optimal put options and their cost: To be conservative, the app 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 of the other names in the table below).
Hedging Costs as of Friday's Close
The hedging costs below are as of Friday's close, and are presented as percentages of position values.
|BAX||Baxter International Inc.||1.98%*|
|ITW||Illinois Tool Works, Inc.||3.65%**|
|XLI||SPDR Select Sector Fund -- Industrials ETF||4.05%**|
SPDR S&P 500 ETF
*Based on optimal puts expiring in August
**Based on optimal puts expiring in September