The 6 Most Active Mid Caps: A Look At Hedging Them

by: David Pinsen

6 Mid Caps With More Than 10 Million Shares Traded

On Wednesday, when the Dow Jones US Mid-Cap Index dropped fractionally, to close at 513.62, there were six mid cap stocks that each had trading volumes of over 10 million shares. The trading volumes on these six stocks ranged from approximately 10.5 million, for MEMC Electronic Materials, Inc. (WFR) to approximately 31 million, for DryShips, Inc. (DRYS).

Of these six stocks, DryShips, Inc. and Renren, Inc. (NYSE:RENN) in particular were extremely expensive to hedge. Recall that we have observed examples of high optimal hedging costs presaging poor performance. The table below shows the costs, as of Wednesday's close, of hedging MEMC, DryShips, Renren, and the other three highest-volume mid caps against greater-than-28% declines over the next several months, using optimal puts.

A Comparison

For comparison purposes, I've added the iShares S&P MidCap 400 Index ETF (NYSEARCA:IJH) and the PowerShares QQQ Trust ETF (NASDAQ:QQQ) to the table. First, a reminder about what optimal puts are, and a note about the 28% decline threshold; then, a screen capture showing the optimal puts to hedge the comparison ETF IJH.

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 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 Thresholds

In this context, "threshold" refers to the maximum decline you are willing to risk in the value of your position in a security. 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). Often, I use 20% thresholds when hedging equities, but two of these stocks, DryShips, Inc. and Renren, Inc. were too expensive to hedge using 20% thresholds (i.e., the cost of hedging them against a greater-than-20% drop was itself greater than 20%, so Portfolio Armor indicated that no optimal contracts were found for them). The smallest decline threshold for which there were optimal puts for Renren, Inc. was 28%, so that's the one I've used for all of the names here.

The Optimal Puts for IJH

Below is a screen capture showing the optimal put option contract to buy to hedge 100 shares of IJH against a greater-than-28% drop between now and August 17th. 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 (the same is true of the other names in the table below).

Hedging Costs as of Wednesday's Close

The hedging costs below are as of Wednesday's close, and are presented as percentages of position values. The stocks are listed in descending order of their share volumes on Wednesday, with the most actively traded stock, DRYS, listed first. As we noted above, some of these names have extremely high hedging costs. If you own these stocks as part of a diversified portfolio, and are content to let that diversification ameliorate your stock-specific risk, but are still concerned about market risk, you may want to consider buying optimal puts on an index-tracking ETF (such as IJH or QQQ) instead, as a way to hedge your market risk.



Hedging Cost

DRYS DryShips, Inc. 22.4%***
DNDN Dendreon Corp. 6.19%***
RENN Renren, Inc. 20.5%*
DF Dean Foods Company 5.84%***
GEN GenOn Energy, Inc. 13.3%**
WFR MEMC Electronic Materials 11.4%*
IJH iShares S&P MidCap 400 2.22%**


PowerShares QQQ Trust


*Based on optimal puts expiring in July

**Based on optimal puts expiring in August

***Based on optimal puts expiring in September

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