Two Ways Of Hedging Cisco Systems
Below are two ways for an investor in Cisco Systems (NASDAQ:CSCO) to hedge 1000 shares against a greater-than-20% drop between now and mid October
1) The first way uses optimal puts*; this way allows uncapped upside, but costs a little more. These were the optimal puts, as of Tuesday's close, for an investor looking to hedge 1000 shares of CSCO against a greater-than-20% drop between now and October 18th:
As you can see at the bottom of the screen capture above, the cost of this protection, as a percentage of position value, was 1.33%.
2) A CSCO investor interested in hedging against the same, greater-than-20% decline between now and mid October, but also willing to cap his potential upside at 20% over that time frame, could have used the optimal collar** below to hedge instead.
As you can see at the bottom of the screen capture above, the net cost of this collar, as a percentage of position value, was 0.75%.
Note that, to be conservative, the cost of both hedges was calculated using the ask price for the optimal puts and the put leg of the optimal collar, and the bid price of the call leg of the optimal collar; in practice, an investor can often buy puts for some price less than the ask price (i.e., some price between the bid and ask) and sell calls for some price higher than the bid price (i.e., some price between the bid and the ask).
*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 PhD to sort through and analyze all of the available puts for your stocks and ETFs, scanning for the optimal ones.
**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. The 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 of optimal hedges above come from the Portfolio Armor iOS app.