Higher vol, higher hedging costs
The Chicago Board Options Exchange Market Volatility Index (VIX) declined 6.77%, to 36.36 on Friday. To illustrate how this level of volatilty affects hedging costs, I've included the two tables below — one showing the hedging costs of a basket of ADRs and ETFs on Friday, August 12, and another showing the hedging costs of the same basket on August 2nd, with the VIX under 25. Before that, though, a quick note of thanks to Tim and my fellow Slopers.
A record week
This has been the best week yet for subscriptions to the web version of Portfolio Armor, and downloads of the Portfolio Armor iOS app, by far. So thanks to those of you who subscribed or downloaded it this week. Between that, a good exit on my JOE puts Monday, and an e-mail this morning that my copy of the Slope of Hope Bathroom Reader is on its way, it's been a good week. Thanks again.
Hedging ADRs with the VIX at 36.36 and at 24.79
The first table below shows the costs as of Tuesday, August 2nd, of hedging eight of the most widely held ADRs against greater-than-20% declines over the next several months, using optimal puts; the second table shows the cost of hedging the same 8 ADRs against the same percentage declines as of Friday, August 12th.
Comparisons
For comparison purposes, I've also included the SPDR S&P 500 Trust ETF (SPY), the SPDR Dow Jones Industrial Average ETF (DIA), the Vanguard Emerging Markets Stock Vipers ETF (VWO), and the Vanguard Europe Pacific ETF (VEA) in both tables. First, a reminder about why I've used 20% as a decline threshold, what optimal puts mean in this context, and why there were no optimal puts for one of the comparison ETFs this week.
Decline Thresholds
The idea for a 20% threshold comes, as I've mentioned before, from a comment fund manager John Hussman made in a market commentary in October 2008:
An intolerable loss, in my view, is one that requires a heroic recovery simply to break even … a short-term loss of 20%, particularly after the market has become severely depressed, should not be at all intolerable to long-term investors because such losses are generally reversed in the first few months of an advance (or even a powerful bear market rally).
Essentially, 20% is a large enough threshold that it reduces the cost of hedging, but is not so large that it precludes a recovery. When hedging, cost is always a concern, which is where optimal puts come in.
Optimal Puts
Optimal puts are the ones that will give you the level of protection you want at the lowest possible cost. As University of Maine finance professor Dr. Robert Strong, CFA has noted, picking the most economical puts can be a complicated task. With Portfolio Armor (available on the web, and as an Apple iOS app), you just enter the symbol of the stock or ETF you're looking to hedge, the number of shares you own, and the maximum decline you're willing to risk (your threshold — you can enter any percentage you like, but the larger the percentage, the greater the chance there will be optimal puts available for the position). Then the app 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.
A Step by Step Example
There is a step by step example of finding optimal puts for a security, with screen shots, in this recent Seeking Alpha article: "Hedging Against a 50% Market Drop."
How Costs Are Calculated
To be conservative, Portfolio Armor calculated the costs below based on the ask prices of the optimal put options. In practice, though, an investor may be able to buy some of these put options for less (i.e., at a price between the bid and the ask).
Why There Were No Optimal Puts for VEA This Week
In some cases, the cost of protection may be greater than the loss you are looking to hedge against. That was the case with the Vanguard Europe Pacific ETF (VEA) this week. As of Friday, August 12th, the cost of protecting against a greater-than-20% decline in VEA over the next several months was itself greater than 20%. Because of that, Portfolio Armor indicated that no optimal contracts were found for it.
Hedging Costs as of August 2, with the VIX at 24.79
The data in the table below is as of Tuesday, August 2nd's close. Coincidentally, the hedging costs were the same for the two different Vanguard ETFs below.
|
Symbol |
Name |
Cost of Protection (as % of position value) |
|
(AMX) |
America Movil SA de CV |
3.46%** |
| (TEVA) | Teva Pharmaceuticals | 9.87%*** |
|
(UBS) |
UBS AG |
7.32%*** |
| (VALE) | Vale S.A. | 4.53%*** |
| (BIDU) | Baidu, Inc. | 10.43%*** |
|
(PBR) |
Petrobras |
3.04%* |
| (ITUB) | Itau Unibanco Holding S.A. | 7.65%*** |
| (VOD) | Vodafone Group plc | 2.91%* |
|
(VWO) |
Vanguard Emerging Markets ETF |
3.84%*** |
| (VEA) | Vanguard Europe Pacific ETF | 3.84%*** |
|
(SPY) |
SPDR S&P 500 |
2.40%*** |
| (DIA) | SPDR Dow Jones Industrial Avg. | 2.37%*** |
Hedging Costs as of August 12, With the VIX at 36.36
The data in the table below is as of Friday, August 12th's close.
|
Symbol |
Name |
Cost of Protection (as % of position value) |
|
(AMX) |
America Movil SA de CV |
4.01%** |
| (TEVA) | Teva Pharmaceuticals | 5.77%*** |
|
(UBS) |
UBS AG |
12.3%*** |
| (VALE) | Vale S.A. | 8.43%*** |
| (BIDU) | Baidu, Inc. | 12.1%*** |
|
(PBR) |
Petrobras |
6.18%* |
| (ITUB) | Itau Unibanco Holding S.A. | 11.8%*** |
| (VOD) | Vodafone Group plc | 4.62%* |
|
(VWO) |
Vanguard Emerging Markets ETF |
10.6%*** |
| (VEA) | Vanguard Europe Pacific ETF | No Optimal Puts At This Threshold |
|
(SPY) |
SPDR S&P 500 |
3.69%*** |
| (DIA) | SPDR Dow Jones Industrial Avg. | 2.60%*** |
*Based on optimal puts expiring in January, 2012.
**Based on optimal puts expiring in February, 2012.
***Based on optimal puts expiring in March, 2012.
Disclosure: I am long optimal puts on DIA as a hedge.
