Of Two Ways To Hedge, One Works Here
In recent posts, we have looked at two ways to hedge stocks: with optimal puts* and with optimal collars**. Optimal puts are generally more expensive, but allow uncapped upside. We often look at hedging against greater-than-20% drops for equities, because that's a decline threshold that's large enough that it reduces the cost of hedging, but not so large that it's an insurmountable decline to recover from. In the case of TSLA on Wednesday, it was too expensive to hedge against a greater-than-20% drop over the next several months using optimal puts, as the screen capture from below explains.
On Wednesday, the cost of hedging TSLA against a greater-than-20% loss over the next several months was itself higher than 20% of your position value, so Portfolio Armor indicated there were no optimal puts available for it.
Hedging TSLA With An Optimal Collar
Although it was too expensive to hedge TSLA against a >20% drop over the next several months with optimal puts, it was not too expensive to hedge it against the same drop using an optimal collar, if you were willing to cap your potential upside by the same percentage over the same time frame. In fact, it was possible to hedge it using a smaller decline threshold and a higher cap. The screen capture below shows the optimal collar, as of Wednesday's close, to hedge 1000 shares of TSLA against a greater-than-18% between now and December 20th, for an investor willing to cap his potential upside at 24% over the same time frame.
As you can see at the bottom of the screen capture above, the net cost of this optimal collar was negative, meaning that the TSLA investor would be getting paid to hedge in this case.
Note that, to be conservative, Portfolio Armor calculates hedging cost based on the ask price of the optimal puts. In practice, an investor can often purchase puts for a lower price, i.e., some price between the bid and ask.
Possibly More Protection Than Promised
*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 Portfolio Armor iOS app.