David Pinsen's  Instablog

Downside Protection For JNK Investors

For investors in the SPDR Barclays High Yield Bond Fund ETF (JNK) considering adding downside protection, here is a way to hedge the ETF against a greater-than-15% drop from its current price over the next several months.

This way uses optimal puts*. These are the optimal puts, as of Wednesday's close, for an investor looking to hedge 1,000 shares of JNK against a greater-than-15% drop between now and December 20th:

As you can see in the screen capture above, the cost of those optimal puts, as a percentage of position value, was fairly low, at 0.72%. Note that, to be conservative, this cost was calculated based on the ask price of the optimal puts; in practice, puts can often be purchased for less, 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 above come from the latest build of the soon-to-come 2.0 version of the Portfolio Armor iOS app. Optimal collar capability will be available as an in-app subscription in the 2.0 version of the app.

Two Ways Of Hedging The iShares MSCI Japan Index ETF

Below are two ways for an investor in Apple, Inc. (AAPL) 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 Wednesday's close, for an investor looking to hedge 1000 shares of AAPL 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 1.43%.

2) An AAPL 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 negative, meaning the Apple investor would have gotten paid to hedge in this case.

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 Ph.D 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 The iShares MSCI Japan Index ETF

Below are two ways for an investor in the iShares MSCI Japan Index ETF (EWJ) 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 Monday's close, for an investor looking to hedge 1000 shares of EWJ 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 1.26%.

2) An EWJ 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 0.76%.

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 Ph.D 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.