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There Goes Tokyo

|Includes: iShares MSCI Japan ETF (EWJ)

There Goes Tokyo

The Nikkei 225 managed to claw back almost a percentage point during Friday's trading session in Japan, after its brutal drop on Thursday. Recall that we looked at hedging the MSCI Japan Index ETF (NYSEARCA:EWJ) in our post last Saturday ("Big in Japan"). In this post, we'll take a quick look at how those puts reacted to that Japan ETF's drop on Thursday, and how the cost of hedging that ETF rose after Thursday's drop.

Hedging The iShares MSCI Japan Index ETF On May 18th

These were the optimal puts*, as of last Friday's close, for an investor looking to hedge 1000 shares of EWJ against a greater-than-20% drop between then and December 20th:

As you can see at the bottom of the screen capture above, the cost of this protection, as a percentage of position value, was 1.24%.

Note that, to be conservative, the cost of this hedge was calculated using the ask price for the optimal puts; 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).

How EWJ Reacted To The Nikkei Plunge On May 23rd

EWJ's drop in Thursday's session in the US wasn't as pronounced as the 7.3% plunge in the Nikkei in Japan the night before:

How The $10 Strike EWJ December Puts Reacted on May 23rd

Incidentally, these happen to be the puts I mentioned buying last week, inspired in part by Tim's post, "Shorting Japanese Hockey Stick" (thanks, Tim!). On May 16th, I used Portfolio Armor to pull up the optimal puts to hedge against a >15% drop in EWJ by December 20th, and the $10 strike puts were the ones that came up, so I bought a few of them**. Here's how they reacted to EWJ's 4.2% drop on Thursday:

I was hoping EWJ would fall as hard Thursday has the Nikkei did in Japan, but this was better than a sharp stick in the eye. It's also a good illustration of the nonlinearity of options, with a 4.2% drop in the underlying security leading to a 158% rise in this out of the money option. That nonlinearity enables an investor to hedge a large underlying position with a much smaller dollar amount of options.

Hedging EWJ After Thursday's Drop

As it turned out, the optimal puts, as of Thursday's close, to hedge 1000 shares of EWJ against a greater-than-20% drop by December 20th were again the $10 strike ones:

Note that the cost of this protection, as a percentage of position value, was 2.84% -- more than double the cost of hedging EWJ against the same percentage drop as of a week ago. The best time to buy protection is before you need it.

*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. The screen captures of optimal hedges above come from the Portfolio Armor iOS app.

**In my case this was a speculative bearish bet, rather than a hedge, because I didn't own any shares of EWJ to protect. I just used the app to find an inexpensively priced put that would appreciate significantly if EWJ fell into a bear market before the end of the year

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

Additional disclosure: I own puts on EWJ.