David Pinsen's  Instablog

There Goes Tokyo

The Nikkei 225 managed to claw back almost a percentage point during Friday's trading session in Japan, after its brutal drop on Thursday. Recall that we looked at hedging the MSCI Japan Index ETF (EWJ) in our post last Saturday ("Big in Japan"). In this post, we'll take a quick look at how those puts reacted to that Japan ETF's drop on Thursday, and how the cost of hedging that ETF rose after Thursday's drop.

Hedging The iShares MSCI Japan Index ETF On May 18th

These were the optimal puts*, as of last Friday's close, for an investor looking to hedge 1000 shares of EWJ against a greater-than-20% drop between then and December 20th:

As you can see at the bottom of the screen capture above, the cost of this protection, as a percentage of position value, was 1.24%.

Note that, to be conservative, the cost of this hedge was calculated using the ask price for the optimal puts; in practice, an investor can often buy puts for some price less than the ask price (i.e., some price between the bid and ask).

How EWJ Reacted To The Nikkei Plunge On May 23rd

EWJ's drop in Thursday's session in the US wasn't as pronounced as the 7.3% plunge in the Nikkei in Japan the night before:

How The $10 Strike EWJ December Puts Reacted on May 23rd

Incidentally, these happen to be the puts I mentioned buying last week, inspired in part by Tim's post, "Shorting Japanese Hockey Stick" (thanks, Tim!). On May 16th, I used Portfolio Armor to pull up the optimal puts to hedge against a >15% drop in EWJ by December 20th, and the $10 strike puts were the ones that came up, so I bought a few of them**. Here's how they reacted to EWJ's 4.2% drop on Thursday:

I was hoping EWJ would fall as hard Thursday has the Nikkei did in Japan, but this was better than a sharp stick in the eye. It's also a good illustration of the nonlinearity of options, with a 4.2% drop in the underlying security leading to a 158% rise in this out of the money option. That nonlinearity enables an investor to hedge a large underlying position with a much smaller dollar amount of options.

Hedging EWJ After Thursday's Drop

As it turned out, the optimal puts, as of Thursday's close, to hedge 1000 shares of EWJ against a greater-than-20% drop by December 20th were again the $10 strike ones:

Note that the cost of this protection, as a percentage of position value, was 2.84% -- more than double the cost of hedging EWJ against the same percentage drop as of a week ago. The best time to buy protection is before you need it.

*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 PhD to sort through and analyze all of the available puts for your stocks and ETFs, scanning for the optimal ones. The screen captures of optimal hedges above come from the Portfolio Armor iOS app.

**In my case this was a speculative bearish bet, rather than a hedge, because I didn't own any shares of EWJ to protect. I just used the app to find an inexpensively priced put that would appreciate significantly if EWJ fell into a bear market before the end of the year

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

Additional disclosure: I own puts on EWJ.

Two Ways Of Hedging Cisco Systems

Below are two ways for an investor in Cisco Systems (CSCO) to hedge 1000 shares against a greater-than-20% drop between now and mid October

1) The first way uses optimal puts*; this way allows uncapped upside, but costs a little more. These were the optimal puts, as of Tuesday's close, for an investor looking to hedge 1000 shares of CSCO against a greater-than-20% drop between now and October 18th:

As you can see at the bottom of the screen capture above, the cost of this protection, as a percentage of position value, was 1.33%.

2) A CSCO investor interested in hedging against the same, greater-than-20% decline between now and mid October, but also willing to cap his potential upside at 20% over that time frame, could have used the optimal collar** below to hedge instead.

As you can see at the bottom of the screen capture above, the net cost of this collar, as a percentage of position value, was 0.75%.

Note that, to be conservative, the cost of both hedges was calculated using the ask price for the optimal puts and the put leg of the optimal collar, and the bid price of the call leg of the optimal collar; in practice, an investor can often buy puts for some price less than the ask price (i.e., some price between the bid and ask) and sell calls for some price higher than the bid price (i.e., some price between the bid and the ask).

*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 PhD to sort through and analyze all of the available puts for your stocks and ETFs, scanning for the optimal ones.

**Optimal collars are the ones that will give you the level of protection you want at the lowest net cost, while not limiting your potential upside by more than you specify. The algorithm to scan for optimal collars was developed in conjunction with a post-doctoral fellow in the financial engineering department at Princeton University. The screen captures of optimal hedges above come from the Portfolio Armor iOS app.

Two Ways Of Hedging Diana Shipping

Below are two ways for an investor in Diana Shipping (DSX) to hedge 1000 shares against a greater-than-20% drop between now and late December.

1) The first way uses optimal puts*; this way allows uncapped upside, but costs a little more. These were the optimal puts, as of Tuesday afternoon, for an investor looking to hedge 1000 shares of DSX against a greater-than-20% drop between now and December 20th:

As you can see at the bottom of the screen capture above, the cost of this protection, as a percentage of position value, was quite expensive, at 9.73%.

2) A DSX investor interested in hedging against the same, greater-than-20% decline between now and late December, but also willing to cap his potential upside at 20% over that time frame, could have used the optimal collar** below to hedge instead.

As you can see at the bottom of the screen capture above, the net cost of this collar, as a percentage of position value, was 0.46%.

Note that, to be conservative, the cost of both hedges was calculated using the ask price for the optimal puts and the put leg of the optimal collar, and the bid price of the call leg of the optimal collar; in practice, an investor can often buy puts for some price less than the ask price (i.e., some price between the bid and ask) and sell calls for some price higher than the bid price (i.e., some price between the bid and the ask).

*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 PhD to sort through and analyze all of the available puts for your stocks and ETFs, scanning for the optimal ones.

**Optimal collars are the ones that will give you the level of protection you want at the lowest net cost, while not limiting your potential upside by more than you specify. The algorithm to scan for optimal collars was developed in conjunction with a post-doctoral fellow in the financial engineering department at Princeton University. The screen captures of optimal hedges above come from the Portfolio Armor iOS app.