Sirius Questions about Hedging and Risk (by Pinsen)

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Hey Fellow Slopers,

This post might be a little basic for some of you, but since Slope has a broad range of readers, I figured this might be educational to some of them.

Yesterday, a financial professional Portfolio Armor subscriber contacted me with a question: he said he’d been unable to find optimal put option contracts to hedge his client’s position in Sirius XM Radio Inc. (SIRI). I sent the note below in response, and since it covers some basics about hedging and risk, I thought it might make an educational blog post. First, though, a quick explanation of what Portfolio Armor does:

How Portfolio Armor Works:

You enter your stock and ETF holdings, and the maximum downside risk you are willing to accept for each holding. Then, using its proprietary algorithm (which was developed by a finance Ph.D. candidate), Portfolio Armor shows you the optimal put options to buy to obtain the level of protection you want at the lowest cost.

How does Portfolio Armor differ from other options tools?

Portfolio Armor is unique in that it shows the optimal put options to buy for you to obtain the precise level of protection that you want at the lowest cost.

What about just scanning Yahoo! Finance or Morningstar to manually find puts to buy?

A very good, experienced, and savvy investor might be able to find the right number of contracts and the right strike price to protect against a certain loss level, but when taking price into account he at risk of paying too much for too little coverage.

My note to the financial professional looking to hedge his client’s SIRI position:

Please see the two attached screen prints. The screen print titled “SIRI Portfolio Armor” shows that 23% is the smallest threshold for which Portfolio Armor was able to find optimal protective put option contracts for SIRI (“threshold” refers to the maximum decline you are willing to risk in your stock or ETF).

What that means is this: if you wanted to protect against a smaller loss in SIRI today (say, a greater-than-20% loss), the cost of protection would be greater than the loss you were looking to protect against (20% of your portfolio value).

That would be like spending $1000 on collision insurance for a car with a Blue Book value of less than $1000: it wouldn’t make sense. Which is why Portfolio Armor doesn’t show any contracts when the cost of protection is greater than the threshold entered.

There are a number of factors that determine how much it costs to hedge a position with protective puts. One of them is the perceived risk of the security. The other screen print, “SIRI Altman Score” shows that SIRI currently has an Altman Z”-Score of about -4.25.

Scores below 1.1 indicate risk of bankruptcy within two years, according to the Altman Z”-Score bankruptcy model (more detail on that here). That risk may help explain why SIRI is so expensive to hedge.

Another factor that affects the cost of hedging is general volatility. Volatility spiked today (due in part, most likely, to fears related to Japan)1. In general, it’s cheaper to hedge when markets are up and volatility is low (“buying umbrellas when it’s sunny out“).

It’s also generally cheaper to buy protection on a diversified ETF (e.g., SPY, which tracks the S&P 500 Index) than to buy protection on an individual stock. An index-tracking ETF such as SPY is subject to market risk, but it’s diversification pretty much eliminates idiosyncratic risk; an individual stock, on the other hand, is subject to both market risk and idiosyncratic risk.

1I wrote this note Wednesday night, after the VIX had spiked about 20% on the day. It fell about 10% today.