Following Up: Optimal Hedging Costs — a Tell For Stocks?

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Happy New Year, Fellow Slopers,

I hope 2012 is a good one for each of you, and for our host.

Lessons from last year

In his post Monday ("A Major Lesson from Last Year"), Tim wrote about two of the most famous hedge fund managers who are long BAC and SHLD, respectively. There's a third money manager (this one a mutual fund guy, rather than a hedgie), whose shareholders had the misfortune of him being long both BAC and SHLD last year: Bruce Berkowitz, Morningstar's "domestic stock fund manager of the decade" for the first decade of this new century:

Meet the domestic stock fund manager of the decade

Berkowitz's Fairhome Fund (FAIRX) closed 2011 down nearly 30%. If the photo above of him looks familiar to you, it may be because you remember it from this Slope guest post of mine from August, "Optimal Hedging Costs: A Tell for Stocks?".

High optimal hedging costs as a tell for stocks

In that post, I speculated that high optimal hedging costs (i.e., high cost of hedging with optimal puts*) might be a red flag, presaging poor future performance for a stock. I mentioned a few examples in that post, one of them being BAC.

A more recent example: SHLD

In a tweet on December 18th (which linked to a Seeking Alpha article in which I updated the hedging costs on Berkowitz's top holdings), I made a similar point about SHLD, which was, at the time, the most expensive of Berkowitz's holdings to hedge, by far:

Looks like a red flag for $SHLD longs. MT @PortfolioArmor Hedging Bruce Berkowitz $AIG $BAC $C $BAM $CIT $BRK.B $JOE

Last Tuesday of course, SHLD fell out of bed, dropping 27% in one day on news that the company was closing 100+ stores following awful Christmas season sales.

The left side of this chart reminds me of the rock in Close Encounters

More data points

As I mentioned in that post back in August, I'd like to do see some more data on optimal puts as a tell for stocks. As I mentioned in that post too, a quant on the Portfolio Armor team has access to a database of historical options prices for this sort of study, but between his academic work and the other projects he's working on for Portfolio Armor, we haven't had a chance to conduct this yet. Maybe we'll get a chance to do so next year, but some of the examples so far (BAC, SHLD, GRPN) have been intriguing.

*About optimal puts

Optimal puts are the ones that will give you the level of protection you want at the lowest possible cost. Portfolio Armor (available on the web and as an Apple iOS app) uses an algorithm developed by a finance Ph.D. to sort through and analyze all of the available puts for a stock or ETF you enter, scanning for the optimal puts.