Hedging Four Stocks Rated "Most Favorable"
Analysts at Thomas White International use industry-specific relative valuation frameworks to determine company valuations and make stock recommendations. In assessing likely performance over the next twelve months, Thomas White analysts assign stocks one of three ratings:
- Buy / Most Favorable. These are stocks expected to outperform the S&P 500.
- Hold / Neutral. These are stocks expected to perform in line with the S&P 500.
- Sell / Unfavorable. These are stocks expected to underperform the S&P 500.
To narrow the list of Most Favorable stocks to ones with high liquidity and potentially more prospects for growth, I screened for Most Favorable-rated Thomas White stocks with market capitalizations of $15 billion and below, and then sorted by daily trading volumes.
One of the stocks that came up near the top of this screen was Valero Energy Corporation (VLO). As we noted in an article last month ("As Oil Prices Drop, A Look At Hedging Refiners"), the recent decline in oil prices could be bullish for Valero and other refiners, as it may lead to higher margins, provided prices for refiners' products (primarily gasoline and diesel) don't decline so much as to offset the benefits of lower imput prices. The table below shows the costs, as of Wednesday's close, of hedging Valero and three other Thomas White "Most Favorable" stocks against greater-than-23% declines over the next several months, using optimal puts.
For comparison purposes, I've added the SPDR S&P 500 ETF (SPY) to the table. First, a reminder about what optimal puts are, and an explanation of the 23% decline threshold. Then, a screen capture showing the optimal put 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.
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 one of these stocks was too expensive to hedge using a 20% threshold (i.e., the cost of hedging it against a greater-than-20% drop was itself greater than 20%, so the algorithm indicated that no optimal contracts were found for it). There were optimal contracts available for all of these names using a decline threshold of 23%, so that's the threshold I've used below.
The Optimal Put to hedge SPY
Below is a screen capture showing the optimal put option contract to hedge 100 shares of the SPDR S&P 500 ETF against a greater-than-23% decline between now and December 21st. A note about this optimal put and its cost: To be conservative, the algorithm 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 Wednesday's Close
The hedging costs below are presented as percentages of position value. Given the high cost of hedging some of these names, 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 SPY) instead, as a way to hedge your market risk.
|SPY||SPDR S&P 500||1.99%*|
*Based on optimal puts expiring in December
**Based on optimal puts expiring in January
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.