Today May Be Your Last Chance To Protect Your Portfolio With These 5 Stocks

Includes: BAC, CSCO, F, GE, SPY
by: Efficient Alpha

If you have been watching the financial news lately, you will have heard about the low volume and volatility seen in the market recently. Volume is usually light in July and August, but this week has been especially light with three of the four lowest days of the year. Volume is often used as a measure of conviction on the part of buyers and sellers, meaning that a rally in shares on low volume is not as strong as one would hope.

The broader market has rallied, nearly 11% in the S&P 500 since the beginning of June, but many investors are concerned that prices will drop when volume and volatility return in September. Volatility is a measure of risk in a stock's price and is the tendency for the shares to fluctuate sharply. It measures magnitude, not directionality of the shares, and is given as an annualized percentage.

Implied volatility is the market's estimate of the stock's volatility over the next 30 trading days and is derived from options prices. I like to compare implied volatility with the average volatility in a stock over the last two years for ideas on where the market may be mispricing volatility. When the implied volatility of a stock falls well below its average volatility, the market may be getting complacent and investors may want to hedge their exposure or use options strategies.

Labor Day seen as the typical return to volume

Over the last 10 years, average volume increased by 13.4% in the 20 days after Labor Day compared to the 20 days before the holiday. In fact, volume increased in each year except 2010 and 2007 when it decreased by 2% and 20%, respectively, following the holiday. Over the last 10 years, stocks in the broad index fell by an average of 1.6% in the month following Labor Day versus an average gain of 2.6% in the previous month. The market has risen 1.4% over the last month on about three billion shares traded daily, just over the 10-year average of 2.9 billion shares.

Volatility may increase today after Chairman Bernanke gives his speech at the Jackson Hole Conference in Wyoming. The head of the FOMC is not expected to promise any additional programs for quantitative easing though he may offer hints as he did with the second round of easing in 2010. Even if volume and volatility do not return today with Chairman Bernanke's speech, the next four weeks offer a busier than normal schedule of important central bank meetings and expected policy announcements. The important point is that when volume and volatility do return, it is usually too late to protect your portfolio. I have hedged some of my exposure over the last couple of weeks and may add to protection today before Bernanke's speech.

4 bellwethers with low implied volatility

General Electric (NYSE:GE) has been doing well as infrastructure and wind turbines add solidly to top-line growth. The company narrowly beat expectations with $0.38 per share earnings for the second quarter, an increase of 11.7% from the same period last year. Shares have a beta of 1.46 and have increased by 12.3% since the beginning of June. Still, the company grows fairly in-line with the general economy and the global economic picture is far from rosy. Headline risks, especially out of Europe, could significantly affect the shares. The shares have an implied volatility of just 19% but have an annualized volatility of 26% over the last two years.

Bank of America (NYSE:BAC) has also outperformed the market as financials finally beat a multi-period losing streak relative to other sectors. The company recently asked a federal court to dismiss a shareholder lawsuit, accusing it of covering up a $10-billion fraud case with American International Group (NYSE:AIG). The fraud case was filed over supposed misrepresentation of $28 billion in mortgage-backed securities sold by Bank of America. The company claims that shareholders were not harmed by the litigation. Previous quarters have shown progress in capital ratios but the never-ending problem in mortgage litigation acts as an overhang to the shares. The stock has an implied volatility of 35% but has an annualized volatility of 50% over the last two years. Shares have a beta of 1.86 and have increased by 12.7% since the beginning of June.

Ford Motor (NYSE:F) has fallen more than 16% since the beginning of the year and has underperformed the general market by 17.7% since the beginning of June. Second-quarter earnings came in above expectations but still fell by 39% from the same quarter last year. Sales in North America continued on a fairly strong basis but all other regions reported lower year-over-year comparisons. The company guided to a full-year loss of more than $1 billion in its European operations and losses may extend into next year as well. The shares have an implied volatility of 26%, but have an annualized volatility of 34% over the last two years. Shares have a beta of 1.64 and have decreased by 7.5% since the beginning of June.

In what seems to be a new fad in patent infringement cases, Ford announced yesterday that it was being accused of infringing on a 2008 patent covering the fuel injection system in its F-150 trucks. The complaint was filed by TMC Fuel Injection System LLC and claims that the company used the injection system after previously telling the inventor it was not interested.

Cisco Systems (NASDAQ:CSCO) surprised the market with plans to return around 50% of its free cash flow to shareholders and an increase in its dividend by 75% when it reported last quarter's earnings. While demand for networking equipment in Europe has remained weak, the growth in data usage across devices has increased the need for Cisco's products. The shares have an implied volatility of 23% but have an annualized volatility of 33% over the last two years. Shares have a beta of 1.38 and have increased by 18.9% since the beginning of June.

Cisco announced yesterday the departure of Paul Mountford, the senior vice president in charge of global sales to businesses, in a year-long restructuring of the company. Mountford had been with the company for 16 years, helping to lead growth in emerging markets before heading up global sales.

Each of the stocks above have betas over 1.0, meaning they tend to be more volatile than the general market. With implied volatility lower than the average volatility over the last two years, option prices are relatively cheap and investors may want to protect their positions by buying put options.

Investors could also hedge risks in their overall portfolio with options strategies using the SPDR S&P500 (NYSEARCA:SPY), an exchange traded fund that tracks the broad index. The shares have an implied volatility of 15% but have an annualized volatility of 19% over the last two years. Shares have increased by 10.2% since the beginning of June. The September put options with a strike price of $141 trade for a premium of $2.78 per share. This means that investors can protect themselves from a decrease in the market past $138 or a drop of 1.6% from Thursday's close. As volatility increases, the premium on the options will increase as well, giving investors a chance to sell out of the protection at a possible profit.

I have a bear-spread in the November options, buying the $141 puts and selling the $138 puts for a net premium of $1.20 per share. This position profits if shares close below $139.80 (1,380 in the S&P500) and my losses are limited to the premium paid.

Disclosure: I am short SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Bear spread in SPY as described.