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An Inexpensive Way To Hedge JPMorgan Chase

|Includes:JPMorgan Chase & Co. (JPM)

Shares of JPMorgan Chase (NYSE:JPM) slid another 2% on Tuesday as news broke that the company was considering making a multibillion dollar payment to settle litigation over the banks role in the mortgage meltdown. For investors looking to add downside protection now, here is an inexpensive way to hedge.

Hedging With An Optimal Collar

Below is the optimal collar*, as of Tuesday's close, to hedge 1000 shares of JPM against a >13% drop between today and March 21st, for an investor willing to cap his potential upside at 9% over the same time frame. Before we look at it, let me anticipate a question:

Why Would I Want To Cap My Upside At 9% For 6 Months?

Well, you might not. In which case, you could pay a lot to hedge, or just take your chances and hope the stock doesn't have a big correction over the next several months. On the other hand, you might be willing to cap your upside here in return for reducing the cost of downside protection, considering the uncertainty surrounding the stock. In that case, here's that optimal collar:

As you can see at the bottom of the screen capture below, the net cost of this optimal collar, as a percentage of position value, was 0.78%.

Note that, to be conservative, Portfolio Armor calculated the cost of this hedge by using the bid price of the call leg and the ask price of the put leg. In practice, you can often sell calls for more (at some price between the bid and ask) and buy puts for less (again, at some price between the bid and ask), so, in actuality, an investor opening the optimal collar above would likely have paid less to do so.

Possibly More Protection Than Promised

In some cases, hedges such as the ones above can provide more protection than promised. For a recent example of that, see this post about hedging shares of BlackBerry (NASDAQ:BBRY).

*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. Portfolio Armor's 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.

Stocks: JPM