In the table below, I've updated the costs (as of Wednesday's close) of hedging the Dow-, NASDAQ 100-, and S&P 500-tracking ETFs against greater-than-20% declines over the next several months, using the optimal puts, along with the costs of similarly hedging a handful of their most widely-traded components. As with the last hedging update post, I included five precious metals ETFs to the table as well. First, though, a quick update on a couple of speculative options bets, and a reminder of why I'm using ITM puts for directional bets and optimal puts for hedging purposes.

Two more speculative options bets

On Wednesday, I got a fill on ITM October calls on Superior Industries (SUP) and ITM December calls on ASM International, NV (ASMI) (I had entered limit orders for several bullish and bearish bets, but those two calls are the ones that I got filled on). Same M.O. with these as I described with COHR earlier this week: using the guidelines Tim mentioned in his book Chart Your Way To Profits, plus the additional guideline of buying options at a ~20%+ discount to model estimates of their fair market value. I mentioned both options buys on Short Screen during the day Wednesday.

Hedging versus betting

To find the optimal puts for hedging, I enter the symbol of the stock or ETF I'm looking to hedge in the “symbol” field of Portfolio Armor (available on the web and as an Apple iOS app), enter the number of shares in the “shares owned” field, and then enter the maximum decline I'm willing to risk in the “threshold” field. Then Portfolio Armor uses its algorithm to scan for the optimal puts to provide that level of protection at the lowest cost.

On rare occasions (I’ve seen it happen once, so far) the optimal puts Portfolio Armor presents might be in-the-money; in most cases, however, they will be out-of-the-money. Since I was making directional bets in the cases above, though, and not hedging, I bought slightly in-the-money options. That makes sense for directional bets (when you are willing to pay more to reduce the odds against your bet) but would be sub-optimal in most cases for hedging (when you want to get a certain level of protection at the lowest possible cost).

Chosing a threshold

When using Portfolio Armor, you can enter any percentage you want in the threshold field (though the larger the percentage you enter, the more likely there will be optimal puts available for that level of protection). As I've mentioned before, the threshold I usually use when I hedge is 20% (i.e., I want protection against any decline worse than that). The idea for a 20% threshold came from a comment fund manager (and Stanford finance Ph.D.) John Hussman made 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

Essentially, 20% is a large enough threshold that it reduces the cost of hedging but not so large that it precludes a recovery. So 20% is the threshold I've used in the table below.

Times to expiration

In his research, the finance academic who developed Portfolio Armor's algorithm found that options with approximately six months to expiration (which today would be the ones expiring in November) tend to offer the best combination of liquidity and cost, so those are the put options for which Portfolio Armor's algorithm aims. When puts with about six months to expiration are not available, Portfolio Armor searches for slightly longer or shorter times to expiration.

A difference in the table this time

Note that, unlike in the table last time, when the hedging costs of the index ETFs QQQ, SPY, and DIA were based on optimal puts expiring in October, this time they are based on optimal puts expiring in December (December 29th, to be exact, in the case of DIA and QQQ, so that's almost 8 months of insurance from today). All things equal, options with expirations further out generally cost more.

*Based on optimal puts expiring in October, 2011

**Based on optimal puts expiring in November, 2011

***Based on optimal puts expiring in December, 2011

Disclosure: I'm holding some puts on DIA, and some calls on SUP, ASMI, and COHR.