Hedging Update (by Dave Pinsen)

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Hey Fellow Slopers,

In our last hedging post, we looked at the cost of hedging the Dow (via the SPDR Dow Jones Industrial Average ETF DIA) and its components. This time, we'll compare the current costs of hedging the Dow with the costs of hedging the NASDAQ 100 (via the PowerShares ETF QQQ) and the S&P 500 (via the SPDR S&P 500 ETF SPY) and a few of their most widely-traded components. First, a quick recap of why an investor might consider hedging now. 

We mentioned a couple of reasons last week:

1) Hedging had gotten cheaper recently, as volatility has declined. Volatility has come down a little more since our last post, with the VIX closing at 16.90 on April 6th, not far from its 52-week low of 14.86.

VIX

2) Prudence may be warranted with the end of QE2 scheduled for the end of June. Last week we quoted David Rosenberg, chief economist at Gluskin Sheff & Associates (formerly chief North American economist at Merrill Lynch, who noted that there had been an 88% correlation between the movements in the Fed balance sheet and the direction of the S&P 500 over the last two years. Rosenberg thought there would be a QE3, but maybe not until next year. I didn't catch it until this week, but apparently Marc Faber told Bloomberg last week that he also expects that there'll be a QE3, but not right away. Faber also said that the Fed might welcome a stock correction as a rationale for implementing QE3 ( at about 3:30 of this clip). 

With that covered, below is a table showing the current costs of hedging the Dow, NASDAQ, and S&P 500 tracking ETFs and a few of their components, against greater-than-20% declines over the next several months using the optimal puts (I used the Portfolio Armor iOS app to pull up the optimal puts for these securities, but you can also use the web app versions of Portfolio Armor). First though, a reminder of what "optimal" means in this context, and also an explanation of why I picked 20% decline thresholds.

The optimal put options are the ones that will give an investor the level of protection he wants at the lowest possible cost. Portfolio Armor uses a proprietary algorithm developed by an all-but-dissertation finance Ph.D. candidate to find the optimal contracts to hedge stocks and ETFs.

You can enter any percentage you like for a threshold when using Portfolio Armor(the the higher the percentage, the greater the chance you will find optimal puts for your position). The idea for a 20% threshold comes 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).

In the table below, unless marked with an asterisk, the optimal put option contracts for the security expire in October; one asterisk indicates the options expire in September; two asterisks indicate that the options expire in November.

Disclosure: I'm holding a few puts on DIA.

Symbol

Name

Cost of Protection (as % of Position value)

INTC

Intel

2.81%

CSCO

Cisco Systems

2.1%

MSFT

Microsoft

2.29%

ORCL

Oracle

2.23%*

BAC

Bank of America

4.66%**

F

Ford

4.39%*

GE

GE

2.09%*

PFE

Pfizer

1.72%*

WFC

Wells Fargo

2.96%

T

AT&T

1.48%

AA

Alcoa

4.8%

QQQ

PowerShares QQQ Trust

1.34%*

SPY

SPDR S&P 500

1.06%*

DIA

SPDR Dow Jones Industrial Average

0.81%*

 

*Based on optimal puts expiring in September, 2011.

**Based on optimal puts expiring in November, 2011.