Hedging The 4 Most Active Mid Caps

Includes: BB, IJH, QQQ, S, SD, SIRI
by: David Pinsen

6 Mid Caps With More Than 10 Million Shares Traded: On Wednesday, when the Dow Jones U.S. Mid-Cap Index dropped fractionally to close at 525.65, there were four mid cap stocks that each had trading volumes of over 35 million shares. The trading volumes on all six stocks ranged from approximately 36 million, for Research In Motion, Ltd. (RIMM) to approximately 44 million, for SandRidge Energy, Inc (NYSE:SD).

Of these four stocks, three 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 Research In Motion, SandRidge Energy, and the other two highest-volume mid caps against greater-than-21% declines over the next several months, using optimal puts.


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 21% decline threshold; then, a screen capture showing the optimal puts to hedge the comparison ETF QQQ.

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 one of these stocks was too expensive to hedge using a 20% threshold (i.e., the cost of hedging it against a greater-than-20% drop was itself greater than 20%, so Portfolio Armor indicated that no optimal contracts were found for it). The smallest decline threshold for which there were optimal puts for all these securities was 21%, so that's the threshold I've used for all of the names here.

The Optimal Puts for QQQ

Below is a screen capture showing the optimal put option contract to buy to hedge 100 shares of QQQ against a greater-than-21% drop between now and December 21st. A note about these optimal put options and their cost: To be conservative, we 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, SD, 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

SD Sandridge Energy 16.8%**
S Sprint Nextel Corp. 15.6%*
SIRI Sirius XM Radio Inc. 8.89%**
RIMM Research in Motion Ltd. 19.1%**
IJH iShares S&P MidCap 400 3.81%*


PowerShares QQQ Trust


*Based on optimal puts expiring in November

**Based on optimal puts expiring in December

Disclosure: I am long optimal puts on QQQ as a hedge against market risk.