Buying umbrellas when it's sunny out
Last week, when the Dow posted its worst weekly performance since October of 2008, I noticed a few articles suggesting it wasn't too late for investors to hedge their stock portfolios. Perhaps not, but a better time to hedge would have been before the correction, when it was less expensive to do so. I like to think of that as buying umbrellas when it's sunny out.
In Seeking Alpha articles such as this one published on April 6th, I suggested equity investors consider hedging, given the low costs at the time. Similarly, in articles such as this one published last month, I suggested gold investors consider hedging when the cost of doing so was relatively low. Today, the cost of hedging the ETF that tracks long Treasury bonds is relatively low. Shareholders of the iShares Barclays 20+ Year Treasury Bond ETF (NYSEARCA:TLT) should consider hedging it.
It's still sunny out for Treasury bonds
The Google Finance chart below shows the performance of the iShares Barclays 20+ Year Treasury Bond ETF (TLT), the SPDR S&P 500 ETF (NYSEARCA:SPY), and the SPDR Gold Shares ETF (NYSEARCA:GLD) since July 1st. 26.33%+ is quite a 3 month run-up for a government bond fund.
It's still relatively inexpensive to hedge TLT
The screen capture below shows the optimal put options to hedge 100 shares of TLT against a greater-than-20% drop over the next several months. The table below that shows the current costs of the same level of optimal put protection on a few gold- and equity-tracking ETFs, which show how inexpensive the hedging costs of TLT are, by comparison. First, though, a reminder about what optimal puts are, then an explanation for why I've used a 20% decline threshold here.
About Optimal Puts
Optimal puts are the ones that will give you the level of protection you want at the lowest possible cost. Portfolio Armor, our hedging tool, 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.
"Decline Threshold" is the maximum decline you are willing to risk in the value of your position. You can enter any percentage you like for a decline threshold when scanning for optimal puts (the higher the percentage though, the greater the chance you will find optimal puts for your position). I have used 20% thresholds here. Essentially, 20% is a large enough threshold that it reduces the cost of hedging, but not so large that it precludes a recovery.
The Optimal Puts For TLT
Below is a screen shot showing the optimal put option contract to buy to hedge 100 shares of TLT against a greater-than-20% drop between now and March, 16, 2012. Note that, 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.
Hedging costs of gold, stock, and Treasury bond ETFs
The data below is as of Monday's close. As in the screen capture above, the costs are based on the ask prices of the optimal put options.
Cost of Protection (as % of position value)
iShares Comex Gold Trust
|GLD||SPDR Gold Shares||2.47%*|
SPDR S&P 500
SPDR Dow Jones Industrials
|TLT||iShares Barclays 20+ Year Treasury Bond||1.27%*|
*Based on optimal puts expiring in March, 2012
**Based on optimal puts expiring in April, 2012
Disclosure: I am long puts on DIA, TLT, and GLD.