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In a Seeking Alpha article published on March 20th ("Hedging a Rally Running on Empty"), we quoted economist David Rosenberg's warning that the rally in equities lacked legs. Fund manager John Hussman offered another warning last week in his market commentary ("Release the Kraken"), in which he described current market conditions as "being in the most negative 1% of historical data based on the average expected return/risk characteristics." In hindsight, it may turn out that Rosenberg came close to calling a near-term market top. As Keith McCullough of Hedgeeye Risk Management noted in this tweet Sunday, the Russell 2000's year-to-date peak was on March 26th:

Russell 2000 is now down -6.5% from its year-to-date peak made on March 26th #GrowthSlowing

- Keith McCullough(@KeithMcCullough) May 6, 2012

With Hussman and Rosenberg's warnings in mind, and prompted by McCullough's tweet, I took a look at the current hedging costs of the four most actively-traded small cap names as of Friday. Two of them had hedging costs that were quite high. Recall that we have observed examples of high optimal hedging costs presaging poor performance. The table below shows the costs, as of Friday's close, of hedging four of the four most actively-traded small caps against greater-than-27% declines over the next several months, using optimal puts.


For comparison purposes, I've added the PowerShares QQQ ETF (NASDAQ:QQQ) and the iShares Russell 2000 Index ETF (NYSEARCA:IWM) to the table. First, a reminder about what optimal puts are, and a note about the 27% decline threshold I've used here. Then, a screen capture showing the optimal put to hedge the comparison ETF, IWM.

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 names using a decline threshold of 27%, so that's the threshold I've used below.

The optimal puts for IWM

Below is a screen capture showing the optimal put option contract to buy to hedge 100 shares of the Russell 2000-tracking ETF IWM against a greater-than-27% drop between now and November 16th. Two notes about this optimal put option and its cost:

  1. Hedging costs for this ETF have more than doubled since mid-March. As we noted in an article published on March 18th, the cost of hedging IWM using a slightly larger decline threshold (28%) was only 1.65% of position value then.
  2. To be conservative, the app calculated the cost based on the ask price of the optimal put. 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).

Costs of hedging against a greater than 27% decline as of Friday's close

The hedging costs below are as of Friday's close, and are presented as percentages of position values. The stocks are listed in descending order of their share volumes on Friday, with the most actively-traded stock, Arch Coal, Inc. (NYSE:ACI), listed first. As we noted above, some of these names have extremely high hedging costs. If you own these stocks 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 may want to consider buying optimal puts on an index-tracking ETF (such IWM or QQQ) instead, as a way to hedge your market risk.



Hedging Cost

ACI Arch Coal, Inc. 9.41%*
SQNM Sequenom, Inc. 16.7%***
NRF Northstar Reality Finance 8.11%***
RAD Rite Aid Corporation 26.9%*
QQQ PowerShares QQQ 1.55%***
IWM iShares Russell 2000 4.00%**

*Based on optimal puts expiring in October

**Based on optimal puts expiring in November

***Based on optimal puts expiring in December

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: I am long optimal puts on QQQ as a hedge against market risk.