The Chicago Board Options Exchange Market Volatility Index (VIX) rose 4.47% Thursday, to close at 20.80. The table below shows the costs, as of Thursday's close, of hedging 18 of 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 what optimal puts mean in this context, and why I've used 20% as a decline threshold.
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 article).
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).
Why There Were No Optimal Puts for TZA and FAZ
In some cases, the cost of protection may be greater than the loss you are looking to hedge against. That was the case with the Direxion Small Cap Bear 3X (TZA) and the Direxion Daily Financial Bear 3X (FAZ). As of Thursday's close, the cost of protecting against greater-than-20% declines in those ETFs over the next several months was itself greater than 20%. Because of that, Portfolio Armor indicated that no optimal contracts were found for them.
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.
|
Symbol |
Name |
Cost of Protection (as % of position value) |
|
SPY |
SPDR S&P 500 |
1.80%* |
| XLF | Financial Select Sector SPDR | 3.23%* |
| QQQ | QQQ Trust | 2.68%* |
| IWM | iShares Russell 2000 Index | 2.93%* |
| SLV | iShares Silver Trust | 5.05%* |
| EEM | iShares MSCI Emerging Markets | 2.80%* |
| EWJ | iShares MSCI Japan | 1.89%* |
| FAS | Direxion Financial Bear 3X | 17.31%* |
| SDS | ProShares Ultra Short S&P 500 | 4.12%* |
| VWO | Vanguard MSCI Emerging MKTS | 3.48%* |
| EFA | iShares MSCI EAFE Index | 3.12%* |
| TZA | Direxion Small Cap Bear 3X | No Optimal Puts |
| XLE | Select Sector SPDR — Energy | 3.10%* |
| FXI | iShares FTSE China 25 Index | 2.94%* |
| XLI | Industrial Select Sector SPDR | 2.03%* |
| SSO | ProShares Ultra S&P 500 | 7.30%* |
| GLD | SPDR Gold Shares | 0.43%* |
| SMH | Semiconductor HOLDRs | 4.87%* |
| GDX | Market Vectors Gold Miners | 4.03%* |
| FAZ | Direxion Daily Financial Bear 3X | No Optimal Puts |
*Based on optimal puts expiring in January, 2012.
