Hedging 12 High-Dividend, Low P/E Stocks

by: David Pinsen

In a Seeking Alpha article on Wednesday ("12 High Dividend Stocks with Low P/E Ratios"), Insider Monkey posted a list of 12 large-cap companies with low P/E ratios. I thought it would be interesting to look at the hedging costs of those stocks. The table below shows the costs, as of Wednesday's close, of hedging those stocks against greater-than-20% declines over the next several months, using optimal puts.

A Comparison

For comparison purposes, I've also added the costs of hedging the SPDR S&P 500 Trust ETF (NYSEARCA:SPY) against the same decline. First, a reminder about what optimal puts mean in this context, and a step by step example of hedging one of these stocks.

About Optimal Puts

Optimal puts are the ones that will give you the level of protection you want at the lowest possible cost. As University of Maine finance professor Dr. Robert Strong, CFA, has noted, picking the most economical puts can be a complicated task. With Portfolio Armor (available on the web and as an Apple iOS app), you just enter the symbol of the stock or ETF you're looking to hedge, the number of shares you own, and the maximum decline you're willing to risk (your threshold). Then the app uses an algorithm developed by a finance Ph.D. to sort through and analyze all of the available puts for your position, scanning for the optimal ones.

A Step By Step Example

Here is a step by step example using one of the high dividend stocks listed below, Duke Energy Corporation (NYSE:DUK).

Step 1: Enter a ticker symbol. In this case, we're using DUK, so we've entered it in the "Ticker Symbol" field below:

[Click all to enlarge]

Step 2: Enter a number of shares. For simplicity's sake, we've entered 100 in the "shares owned" field below, but you could also enter an odd number, e.g., 731. In that case, Portfolio Armor would round down the number of shares of DUK you entered to the nearest hundred (since one put option contract represents the right to sell one hundred shares of the underlying security), and then present you with seven of the put option contracts that would slightly over-hedge the 700 shares of DUK they cover, so that the total value of the 731 shares of DUK would be protected against a greater-than-20% decline.

Step 3: Enter a decline threshold. You can enter any percentage you like for a threshold when using Portfolio Armor (the higher the percentage though, the greater the chance you will find optimal puts for your position). The idea for a 20% threshold comes, as I've mentioned before, from a comment fund manager John Hussman made in a market commentary in October 2008:

An intolerable loss, in my view, is one that requires a heroic recovery simply to break even … a short-term loss of 20%, particularly after the market has become severely depressed, should not be at all intolerable to long-term investors because such losses are generally reversed in the first few months of an advance (or even a powerful bear market rally).

Essentially, 20% is a large enough threshold that it reduces the cost of hedging but not so large that it precludes a recovery, so we've entered 20% in the Threshold field in the screen cap below.

Step 4: Tap the "Done" button. A moment after tapping the blue button, you'd see the screen cap below, which shows the optimal put option contracts to buy to hedge 100 shares of DUK against a >20% drop between now and April 20, 2012.

A note about these optimal put options and their cost: To be conservative, Portfolio Armor calculated the 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 the ask.

Volatility and Hedging Costs

As volatility has climbed, so have hedging costs. The VIX S&P 500 volatility index closed at 33.38 on Wednesday. On June 16, when the VIX was at 22.73, the cost of hedging SPY against a >20% decline over the same length of time was only 1.64%, as we noted an article published the following day. As the table below shows, as of Wednesday, the cost as a percentage of position was 3.44%.

Hedging Costs As Of Wednesday's Close

The hedging data in the table below is as of Wednesday's close, and is presented as a percentage of position value. The yield data is from Inside Monkey's article published on Wednesday.

Dividend Yield

Hedging Cost

CenturyLink, Inc.




Duke Energy Corporation




Entergy Corporation




Eli Lilly & Co.




Altria Group Inc.




Annaly Capital Management




Progress Energy Inc.




Reynolds American Inc.




Southern Copper Corp.




AT&T, Inc.




Verizon Communications Inc.




Williams Partners L.P.




SPDR S&P 500 Trust (SPY)
2.1% 3.44%**

*Based on optimal puts expiring in February, 2012

**Based on optimal puts expiring in March, 2012

***Based on optimal puts expiring in April, 2012

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