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"History doesn't repeat itself, but it does rhyme" -- Mark Twain

In a few articles during the second quarter of 2011 (this one, for example), I mentioned a couple of reasons why investors might have wanted to consider hedging their stocks then:

  1. With stock market volatility declining recently [...] it has gotten cheaper to hedge. [...]
  2. Prudence may be warranted with the end of the second round of the Fed's quantitative easing (QE2) scheduled for the end of June. On Bloomberg TV [...] economist David Rosenberg (formerly, Merrill Lynch's chief North American economist) noted that there'd been an 88% correlation between the movements in the Fed balance sheet and the direction of the S&P 500 over the last two years.

At the end of the second quarter, the S&P 500 Volatility Index (VIX) closed at 16.52; by the end of the third quarter last year, the VIX closed at 42.96. David Rosenberg's warning also proved prescient, as the S&P 500 declined 14.3% during the 3rd quarter.

Flash forward to today and there are two similarities:

  • Volatility has again been declining recently (as the graph below shows, the VIX is hovering near two-year lows).


  • David Rosenberg has offered another warning. In a Financial Times column last week ("Stock market rally is running on empty"), Rosenberg offered a glimmer of current opportunities, noting that "tech and financials screen well when their price/earnings ratio is bench marked against growth estimates for the next three years, a measure known as a PEG ratio," before noting a number of reasons (a lack of participation by retail investors, heavy selling by corporate insiders, anomalous economic data due to the warm winter) why the current equity rally lacks legs.


Given Rosenberg's recent warning, investors may want to consider taking advantage of the current low volatility and relatively low hedging costs to hedge their portfolios. Since Rosenberg wrote positively about low-PEG techs and financials, the table below shows the costs of hedging four low-PEG techs and financials against greater-than-23% declines over the next several months, using optimal puts.

A Comparison

For comparison purposes, I've also included the costs of hedging the SPDR S&P 500 Trust ETF (NYSEARCA:SPY) against the same decline. First, a reminder about what optimal puts are, and a note about the 20% decline threshold. Then, a clarification about the correlations between the VIX and optimal hedging costs we've observed, followed by a screen capture showing the current optimal puts to hedge the comparison ETF, SPY.

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 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).

Often, I use 20% thresholds when hedging equities, but two of these stocks were too expensive to hedge using 20% thresholds (i.e., the cost of hedging them against a greater-than-20% drop was itself greater than 20%, so Portfolio Armor indicated that no optimal contracts were found for them). There were optimal contracts available for all of these stocks using a decline threshold of 23%, so that's the threshold I've used below.

The VIX And Observed Optimal Hedging Costs

The VIX, the CBOE Volatility Index, shows the market's expectation of 30-day volatility, and is constructed using the implied volatilities of a range of S&P 500 index options, both calls and puts. Portfolio Armor, in scanning for optimal put options to hedge underlying securities, looks at puts with expirations approximately six months out. So the VIX is not calculated using the same set of options Portfolio Armor scans. Nevertheless, we have observed correlations between VIX levels and the costs Portfolio Armor shows for hedging index ETFs with optimal puts. For illustration purposes, here are a couple of examples from last year.

  1. On June 23nd, 2011, when the VIX closed at 19.29, cost of hedging SPY against a greater-than-20% decline over approximately the next 6 months was 1.40% of position value.
  2. On September 30th, 2011, when the VIX closed at 42.96, the cost of hedging SPY against a greater-than-20% decline over approximately the next 6 months was 4.69% of position value.

The Optimal Puts For SPY

Below is a screen capture showing the optimal put option contract to buy to hedge 100 shares of the SPDR S&P 500 ETF against a greater-than-23% drop between now and September 21st. A note about these optimal put options and the 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 hedging data in the table below is as of Monday's close, and is presented as percentages of position values. PEG values are as of Monday's close as well.

Note that the costs of hedging two of these stocks, Newcastle Investment Corp. (NYSE:NCT) and Alcatel Lucent (NYSE:ALU), were particularly high. Recall that we've observed examples of high optimal hedging costs presaging poor performance. If you own an expensive-to-hedge stock as part of a diversified portfolio, and are content to let that diversification ameliorate your stock-specific risk -- but are still concerned about market risk -- you might consider hedging your market risk by buying optimal puts on an index-tracking ETF such as SPY.

Symbol

Name

PEG

Hedging Cost

Financial Stocks
JEFJefferies Group0.816.56%***
NCTNewcastle Inv.0.3822.7%*
Tech Stocks
ALUAlcatel Lucent.7920.2%**
ATMLAtmel Corporation.808.10%*
Comparison ETF
SPYSPDR S&P 500NA1.16%**

*Based on optimal puts expiring in August

**Based on optimal puts expiring in September

***Based on optimal puts expiring in October

Source: Hedging A Rally 'Running On Empty'