Hedging Update — ETFs

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The Chicago Board Options Exchange Market Volatility Index (VIX) dropped 2.39% Thursday, to close at 15.95. The table below shows the costs, as of Thursday's close, of hedging the 20 most actively-traded ETFs against greater-than-20% declines over the next several months, using the optimal puts for that. First, a reminder about why I've used 20% as a decline threshold and what optimal puts mean in this context.

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). Then the app uses an algorithm developed by a finance academic to sort through and analyze all of the available puts for your position, scanning for the optimal ones (there's an example of this, with screen shots, in this recent article regarding the last ETF in the table below, TLT).

Decline Thresholds

You can enter any percentage you like for a threshold when using Portfolio Armor (the higher the percentage though, the greater the chance you will find optimal puts for your position). 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 not so large that it precludes a recovery. When hedging, cost is always a concern, which is where optimal puts come in.

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).

Hedging costs as of Thursday

The data in the table below is as of Thursday's close. The ETFs are listed in order trading volume Thursday, with the most actively-traded name (SPY) at the top.



Cost of Protection (as % of position value)


SPDR S&P 500


IWMiShares Russell 2000 Index2.25%*
EWJiShares MSCI Japan1.78%*
EEMiShares MSCI Emerging Markets2.25%*
XLFFinancial Select Sector SPDR1.92%*
XLIIndustrial Select Sector SPDR1.85%*
XLESelect Sector SPDR — Energy2.10%*
EFAiShares MSCI EAFE Index2.03%*
EWZiShares MSCI Brazil Index3.86%*
USOUnited States Oil3.52%*
XLKTechnology Select Sector SPDR1.39%*
SMHSemiconductor HOLDRs2.42%*
XLBMaterials Select Sector SPDR2.66%*
EWTiShares MSCI Taiwan Index2.61%*
IYRiShares Dow Jones Real Estate1.92%*
XLUUtilities Select Sector SPDR0.97%*
XLYConsumer Discretionary SPDR1.59%*
XLVHealth Care Select SPDR1.11%*
XLPConsumer Staples Select SPDR0.75%*
TLTiShares Barclays 20+ Yr. Treas.0.74%*

*Based on optimal puts expiring in January, 2012.