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To determine a stock's fair value, Standard & Poor's uses a proprietary quantitative model that incorporates factors such as earnings growth potential, price-to-book value and return on equity. It then uses the results of that model to rank stocks from 1 to 5: Stocks with ranking of 5 are considered to be significantly undervalued, and stocks with a ranking of 1 are considered to be most overvalued. Since overvalued stocks may have more downside risk in the event of a market correction, I was curious about the costs of hedging a sample of stocks considered overvalued by Standard & Poor's. Using Fidelity's screener, on Friday, I screened for optionable stocks that had Standard & Poor's Fair Value Ranks of "1" (most overvalued) and also met these two additional criteria for size and liquidity:

  • Market capitalizations between $500 million and $2 billion
  • Daily volume of 2 million shares or more traded

A total of 17 stocks came up on this screen. The table below shows four of the more actively-traded of these stocks, along with the costs, as of Friday afternoon, of hedging them against greater-than-20% declines over the next several months, using optimal puts.

A Comparison

For comparison purposes, I've added the iShares S&P Small Cap 600 Index ETF (IJR) to the table. First, a reminder about what optimal puts are, and an explanation of the 20% decline threshold. Then, a screen capture showing the optimal put to hedge the comparison ETF, IJR.

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). I have used 20% decline thresholds for each of the names below.

The Optimal Put to Hedge IJR

Below is a screen capture of the optimal put option contract to hedge 100 shares of the iShares S&P Small Cap 600 Index ETF against a greater than 20% decline as of intraday Friday. A note about this optimal put and its cost: 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).

Hedging Costs As Of Intraday Friday

The hedging costs below are presented as percentages of position value. Given the double-digit costs of hedging these four stocks, if you own them 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 buying optimal puts on an index-tracking ETF (such as IJR) instead, as a way to hedge your market risk. A less expensive way of hedging market risk, if you believe that small caps will roughly track the broader market in a downturn, would be to buy optimal puts on an ETF such as the SPDR S&P 500 (SPY). SPY is significantly cheaper to hedge now than IJR - the cost of hedging SPY against a greater-than-20% drop between now and December 21st, as a percentage of position value, is only 2.18%.

Symbol

Name

Hedging Cost

KBH KB Home 14.2%*
AKS AK Steel Holding Corp. 15.8%***
CIEN

Cienta Corp.

10.4%*

USG

USG Corporation

18.8%**

IJR iShares S&P SmallCap 600 5.19%**

*Based on optimal puts expiring in October

**Based on optimal puts expiring in November

***Based on optimal puts expiring in December

Source: 4 Overvalued Small Caps And The Costs Of Hedging Them