Wells Fargo: Is That What You Call Success?

Wells Fargo reported Q4 results that missed analyst estimates. The large bank still trades at the high end of sector valuations, despite a relative underperformance over the last three months. Investors should remember that success is all relative. Before the open on Friday, Wells Fargo (NYSE:WFC) reported quarterly earnings along with a group of large financials. The troubled bank

Hedging Update

Hey fellow Slopers,

Below is a hedging update as of Friday's close. Before that, a quick housekeeping note. A few of you have asked in the comments of previous posts when we're adding the optimal collar capability to Portfolio Armor. The short answer is that we plan to add that and optimal calls to hedge short positions later this quarter, but if you'd like more details on what we've got planned, see this post, which also includes a coupon code for the site.

Hedging Update

The VIX S&P 500 Volatility Index fell fractionaliy Friday, closing at 36.30. That makes more than two months of closes above 30. Not surprisingly, since then, equities and equity ETFs have been expensive to hedge. Treasury ETFs are still relatively inexpensive to hedge though, again, unsurprising, given the run Treasuries have had.

The table below shows the costs, as of Friday's close, of hedging a basket of stocks and ETFs against greater-than-20% declines over the next several months, using optimal puts. First, a reminder about what optimal puts are, and why I've used 20% as a decline threshold; then, a screen capture showing the current optimal puts to hedge one of the Treasury ETFs listed below, iShares Barclays 20yr+ T-Bond (TLT).


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 your stocks and ETFs, scanning for the optimal ones.

Decline Thresholds

In this context, "threshold" refers to the maximum decline you are willing to risk in the value of your position in a security. You can enter any percentage you like for a decline threshold when scanning for optimal puts (the higher the percentage though, the greater the chance you will find optimal puts for your position). I have used 20% thresholds for each of the securities below. Essentially, 20% is a large enough threshold that it reduces the cost of hedging, but not so large that it precludes a recovery.

The Optimal Puts for TLT

Below is a screen shot showing the optimal put option contracts to buy to hedge 100 shares of IEF against a greater-than-20% drop between now and March, 16, 2012.

One note about the cost of these optimal puts: to be conservative, Portfolio Armor calculated the cost based on their ask price. In practice, an investor can often purchase puts for a lower price, i.e., some price between the bid and the ask.



Why There Were No Optimal Puts for BAC

In some cases, the cost of protection may be greater than the loss you are looking to hedge against. That was the case with Bank of America (BAC). On Friday, the cost of protecting against a greater-than-20% decline in BAC shares over the next several months was itself greater than 20%. Because of that, Portfolio Armor indicated that no optimal contracts were found for it.

Hedging costs as of Friday's close

Symbol

Name

Cost of Protection (as % of Position value)

     
 

Widely-Traded Stocks

 

INTC

Intel

6.64%**

CSCO

Cisco Systems

6.96%**

MSFT

Microsoft

5.33%**

AAPL

Apple, Inc.

7.00%**

BAC

Bank of America

No Optimal Contracts

F

Ford

10.4%*

GE

GE

7.48%*

PFE

Pfizer

4.12%*

WFC

Wells Fargo

12.0%**

T

AT&T

3.48%**

 

Major Index ETFs

 

QQQ

PowerShares QQQ Trust

4.09%*

SPY

SPDR S&P 500

3.66%*

DIA

SPDR Dow Jones Industrial Avg

3.60%*

 

Precious Metals ETFs

 

GLD

SPDR Gold Trust

2.45%*

SLV

iShares Silver Trust

11.8%**

SGOL

ETFS Physical Swiss Gold Shrs

2.71%*

SIVR

ETFS Physical Silver Shares

10.4%*

  Treasury Bond and Note ETFs  
TLT iShares Barclays 20yr+ T-Bond 1.14%*
IEF iShares Lehman 7-10 yr T-Note 0.48%*

*Based on optimal puts expiring in March, 2012

**Based on optimal puts expiring in April, 2012


Hedging Update (by Dave Pinsen)

A month of closes over 30 for the VIX

The VIX rose 2.82% on Thursday, closing at 34.32. Since the market meltdown of August 5th, it hasn't closed below 30 on any day. Something I've mentioned in previous posts, when the VIX was below 20 (e.g., this one) is that long investors ought to consider hedging when volatility is low, and hedging costs are relatively low as well. Since August 5th, that hasn't been the case.

Hedging Update

The table below shows the costs, as of Thursday's close, of hedging a basket of stocks and ETFs against greater-than-20% declines over the next several months, using optimal puts (if there are any optional stocks or ETFs you'd like to see added for future updates, feel free to mention them). First, a reminder about what optimal puts mean in this context, and a step by step example of finding optimal puts for one of the ETFs listed below (GLD). 

 

 

About 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 Ph.D to sort through and analyze all of the available puts for your position, scanning for the optimal ones.

A Step By Step Example

Here is a step by step example of finding the optimal puts for the comparison ETF listed below, SPDR Gold Shares (GLD).

Step 1: Enter a ticker symbol. In this case, we're using GLD, so we've entered it in the "Ticker Symbol" field below:



Step 2: Enter a number of shares.
For simplicity's sake, we've entered 100 in the "shares owned" field below, but you could also enter an odd number, e.g., 731. In that case, Portfolio Armor would round down the number of shares of GLD you entered to the nearest hundred (since one put option contract represents the right to sell one hundred shares of the underlying security), and then present you with seven of the put option contracts that would slightly over-hedge the 700 shares of GLD they cover, so that the total value of the 731 shares of GLD would be protected against a greater-than-20% decline.



Step 3: Enter a decline threshold. 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, so we've entered 20% in the Threshold field in the screen cap below.



Step 4: Tap the "Done" button. A moment after tapping the blue button, you'd see the screen cap below, which shows the optimal put option contracts to buy to hedge 100 shares of GLD against a >20% drop between now and March 16, 2012. Two notes about these optimal put options and their cost:

  • To be conservative, Portfolio Armor calculated the cost based on the ask price of the optimal puts. In practice an investor can often purchase puts for a lower price, i.e., some price between the bid and the ask.
  • As volatility has climbed, so have hedging costs. Three months ago, the cost of hedging GLD against a >20% drop over the same length of time was 0.49%, as we noted in this hedging update back on June 2nd. As the screen shot below shows, as of Thursday, the hedging cost as a percentage of position was 1.71%.


Why There Were No Optimal Puts for BAC

In some cases, the cost of protection may be greater than the loss you are looking to hedge against. That was the case with Bank of America (BAC). On Thursday, the cost of protecting against a greater-than-20% decline in BAC shares over the next several months was itself greater than 20%. Because of that, Portfolio Armor indicated that no optimal put option contracts were found for it.

Hedging costs as of Thursday's close

Symbol

Name

Cost of Protection (as % of Position value)

     
 

Widely-Traded Stocks

 

INTC

Intel

5.13%***

CSCO

Cisco Systems

5.71%***

MSFT

Microsoft

5.19%***

ORCL

Oracle

7.30%**

BAC

Bank of America

No Optimal Contracts

F

Ford

11.9%**

GE

GE

7.38%**

PFE

Pfizer

4.14%**

WFC

Wells Fargo

10.0%***

T

AT&T

4.29%***

AA

Alcoa

10.2%***

 

Major Index ETFs

 

QQQ

PowerShares QQQ Trust

3.73%**

SPY

SPDR S&P 500

3.60%**

DIA

SPDR Dow Jones Industrial Average

3.19%**

 

Precious Metals ETFs

 

GLD

SPDR Gold Trust

1.71%**

SLV

iShares Silver Trust

8.85%***

DBP

PowerShares DB Precious Metals

13.7%***

SGOL

ETFS Physical Swiss Gold Shares

2.00%**

SIVR

ETFS Physical Silver Shares

7.38%**

     

*Based on optimal puts expiring in February, 2012

**Based on optimal puts expiring in March, 2012

***Based on optimal puts expiring in April, 2012

 Disclosure: I'm holding puts on GLD and DIA


Hedging Update — BAC Again

BAC Again

In a post last week ("Optimal Hedging Costs: A Tell for Stocks"), we mentioned that Bank of America (BAC) had the highest hedging costs in the Dow for most of the last several months, and we speculated about how those high hedging costs might have been a red flag for BAC longs. BAC is up about 28% since then, on news of Warren Buffett's $5 billion preferred stock investment in the Berkshire holding. But as David Weidner noted on Tuesday, Buffett followers who piled into the common stock of Goldman Sachs and General Electric after previous preferred stock investments by Buffett are still under water. 

As if to underscore that risk, take a look at which name in the table below had the highest hedging costs as of Tuesday.

Hedging update

The table below shows the costs, as of Tuesday's close, of hedging BAC along with a basket of other stocks and ETFs against greater-than-20% declines over the next several months, using optimal puts.  First, a reminder about what optimal puts mean in this context, then a step by step example of finding optimal puts for one of the ETFs listed below (QQQ).

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 Ph.D to sort through and analyze all of the available puts for your position, scanning for the optimal ones.

A Step by Step Example

Here is a step by step example of finding the optimal puts for one of the ETFs listed below, QQQ.

Step 1: Enter a ticker symbol

In this case, we're using QQQ, so we've entered it in the "Ticker Symbol" field below:



Step 2: Enter a number of shares


For simplicity's sake, we've entered 100 in the "shares owned" field below, but you could also enter an odd number, e.g., 631. In that case, Portfolio Armor would round down the number of shares of QQQ you entered to the nearest hundred (since one put option contract represents the right to sell one hundred shares of the underlying security), and then present you with 6 of the put option contracts that would slightly over-hedge the 600 shares of QQQ they cover, so that the total value of the 631 shares of QQQ would be protected against a greater-than-20% decline.




Step 3: Enter a decline threshold

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. So we've entered 20% in the Threshold field in the screen cap below.



Step 4: Tap the "Done" button

A moment after tapping the blue button, you'd see the screen cap below, which shows the optimal put option contracts to buy to hedge 100 shares of QQQ against a >20% drop between now and March 16, 2012. Two notes about these optimal put options and their cost:

  • To be conservative, Portfolio Armor calculated the cost based on the ask price of the optimal puts. In practice an investor can often purchase puts for a lower price, i.e., some price between the bid and the ask.
  • As volatility has climbed, so have hedging costs. The VIX S&P 500 volatility index closed at 32.89 on Tuesday. On May 25th, when the VIX was at 17.07, the cost of hedging QQQ against a >20% decline over the same length of time was only 1.64%, as we noted in this article published the following day. As the screen shot below shows, as of Tuesday, the cost as a percentage of position was 3.95%.



Hedging costs as of Tuesday's close

Symbol

Name

Cost of Protection (as % of Position value)

     
 

Widely-Traded Stocks

 

INTC

Intel

3.46%*

CSCO

Cisco Systems

4.73%*

MSFT

Microsoft

2.90%*

ORCL

Oracle

5.63%***

BAC

Bank of America

16.8%**

F

Ford

9.57%***

GE

GE

6.08%***

PFE

Pfizer

3.92%***

WFC

Wells Fargo

6.73%*

T

AT&T

2.16%*

AA

Alcoa

6.55% *

 

Major Index ETFs

 

QQQ

PowerShares QQQ Trust

3.57%***

SPY

SPDR S&P 500

3.61%***

DIA

SPDR Dow Jones Industrial Average

3.25%***

 

Precious Metals ETFs

 

GLD

SPDR Gold Trust

1.51%***

SLV

iShares Silver Trust

5.45%*

DBP

PowerShares DB Precious Metals

1.34%*

SGOL

ETFS Physical Swiss Gold Shares

1.92%***

SIVR

ETFS Physical Silver Shares

8.73%***

     

*Based on optimal puts expiring in January, 2012

**Based on optimal puts expiring in February, 2012

***Based on optimal puts expiring in March, 2012


Hedging Update

Hedging when volatility is low

Something I've mentioned in previous posts (such as this one, "Plan not to Panic") is that investors ought to consider hedging when volatility is low, and hedging costs are relatively low as well. That's not the case now, as you can see from the second table below. Nevertheless, if Portfolio Armor downloads and subscriptions are any guide, every day the market tanks, more investors start thinking about hedging. It seems that some long investors start shopping for umbrellas after they get soaked.


If Tim's dead cat bounce scenario comes to pass, maybe volatility will come down briefly then and investors will get another chance to hedge at relatively low costs before the next leg down.

Hedging with the VIX at 16.27 and at 43.05

The first table below shows the costs as of Thusday, April 14th, when the VIX was at 16.27, of hedging a basket of widely held stocks and ETFs against greater-than-20% declines over the next several months, using optimal puts; the second table shows the cost of hedging the same basket of stocks and ETFs against the same percentage declines as of Friday, August 19th, with the VIX at 43.05.

First, a reminder about why I've used 20% as a decline threshold, and what optimal puts mean in this context.

Decline Thresholds

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 is not so large that it precludes a recovery. When hedging, cost is always a concern, which is where optimal puts come in.

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 -- you can enter any percentage you like, but the larger the percentage, the greater the chance there will be optimal puts available for the position). Then the app uses an algorithm developed by a finance Ph.D. to sort through and analyze all of the available puts for your position, scanning for the optimal ones.

A Step by Step Example

There is a step by step example of finding optimal puts for a security, with screen shots, in this recent Seeking Alpha article: "Hedging Against a 50% Market Drop."

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 April 14th, with the VIX at 16.27

The data in the table below is as of Friday, April 14th's close


Symbol

Name

Cost of Protection (as % of Position value)

     
 

Widely-Traded Stocks

 

INTC

Intel

3.06%**

CSCO

Cisco Systems

3.09%**

MSFT

Microsoft

2.00%**

ORCL

Oracle

2.07%*

BAC

Bank of America

6.02%***

F

Ford

4.32%*

GE

GE

2.35%*

PFE

Pfizer

1.51%*

WFC

Wells Fargo

4.71%**

T

AT&T

1.55%**

AA

Alcoa

3.57% **

 

Major Index ETFs

 

QQQ

PowerShares QQQ Trust

1.48%*

SPY

SPDR S&P 500

1.04%*

DIA

SPDR Dow Jones Industrial Average

0.82%*

 

Precious Metals ETFs

 

GLD

SPDR Gold Trust

0.31%*

SLV

iShares Silver Trust

4.48%**

DBP

PowerShares DB Precious Metals

1.4%**

SGOL

ETFS Physical Swiss Gold Shares

1.09%*

SIVR

ETFS Physical Silver Shares

3.82%*

     

*Based on optimal puts expiring in September, 2011

**Based on optimal puts expiring in October, 2011

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


Hedging Costs as of August 19th, with the VIX at 43.05

The data in the table below is as of Friday, August 19th's close.

Why There Were No Optimal Puts for BAC This Week

In some cases, the cost of protection may be greater than the loss you are looking to hedge against. That was the case with BAC this week. As of Friday, August 19th, the cost of protecting against a greater-than-20% decline in BAC over the next several months was itself greater than 20%. Because of that, Portfolio Armor indicated that no optimal contracts were found for it.

 

Symbol

Name

Cost of Protection (as % of Position value)

     
 

Widely-Traded Stocks

 

INTC

Intel

5.84%*

CSCO

Cisco Systems

7.16%*

MSFT

Microsoft

4.45%*

ORCL

Oracle

7.95%***

BAC

Bank of America

No Optimal Puts at this Threshold

F

Ford

15.0%***

GE

GE

9.87%***

PFE

Pfizer

4.70%***

WFC

Wells Fargo

9.67%*

T

AT&T

3.07%*

AA

Alcoa

8.92% *

 

Major Index ETFs

 

QQQ

PowerShares QQQ Trust

5.08%***

SPY

SPDR S&P 500

4.56%***

DIA

SPDR Dow Jones Industrial Average

4.73%***

 

Precious Metals ETFs

 

GLD

SPDR Gold Trust

1.50%***

SLV

iShares Silver Trust

5.71%*

DBP

PowerShares DB Precious Metals

1.77%*

SGOL

ETFS Physical Swiss Gold Shares

1.85%***

SIVR

ETFS Physical Silver Shares

9.18%***

     

*Based on optimal puts expiring in January, 2012

**Based on optimal puts expiring in February, 2012

***Based on optimal puts expiring in March, 2012



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Banks will show us the way

Bank of America will soon approach its financial crisis low, and Citibank, despite a 10 for 1 split is back on its way to single digits. What are the implications? For starters, let's recognize that banks are still an integral part of the economy, as is debt.Viewing the remainder of this article requires a Subscription

Hedging Update — Stocks

Bank of America (BAC) was the most actively traded NYSE stock Tuesday (as it was last week), but after posting its 90 cent per share Q2 loss Tuesday, the costs of hedging it have gone up. The table below shows the costs, as of Tuesday's close, of hedging BAC and 19 of the other most actively-traded stocks against greater-than-20% declines over the next several months, using the optimal puts.

Comparisons

For comparison purposes, I've also added the costs of hedging the SPDR S&P 500 Trust ETF (SPY), the SPDR Dow Jones Industrial Average ETF (DIA), the Nasdaq 100-tracking ETF PowerShares QQQ Trust ETF (QQQ), and the U.S. Treasury Bond tracking ETF iShares Barclays 20+ Year Treasury Bond ETF (TLT) against the similar declines. 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 screenshots, in this article about hedging against a US default with puts on 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 Tuesday's close

The data in the table below is as of Tuesday's close. After the four ETFs listed for comparison purposes, the NYSE stocks are listed in order of their share volume in Tuesday's trading, with the most actively traded stock (BAC) listed first; the Nasdaq stocks are listed in a similar order, with the most actively traded Nasdaq stock (SIRI) listed first.

Symbol

Name

Cost of Protection (as % of position value)

  Comparison Index ETFs  

SPY

SPDR S&P 500

1.53%*

DIA SPDR Dow Jones Industrial Avg 1.40%*
QQQ PowerShares QQQ Trust 2.11%*
TLT
iShares Barclays 20+ Year Treas
0.61%
  NYSE Stocks  
BAC Bank of America Corporation 7.94%*
WFC
Wells Fargo & Co.
3.66%*
S
Sprint Nextel Corp.
5.51%*
F
Ford
3.67%*
GE General Electric Company 3.12%*
HK
Petrohawk Energy Corporation
0.78%*
MGM
MGM Resorts International 9.19%*
JPM
JP Morgan Chase & Co. 3.64%*
PFE
Pfizer, Inc. 3.11%*
C
Citigroup Inc.
4.52%*
  Nasdaq Stocks  
SIRI
Sirius XM Radio Inc. 10.4%*
MSFT Microsoft Corporation 2.94%*
NWSA News Corporation 6.33%*
CSCO Cisco Systems, Inc. 4.09%*
INTC
Intel Corporation 3.38%*
MU Micron Technologies 13.8%*
YHOO
Yahoo! Inc.
4.11%*
ORCL Oracle Corp. 3.65%*
DELL
Dell, Inc.
4.02%*
AAPL
Apple, Inc.
2.80%*

*Based on optimal puts expiring in January, 2012.

Disclosure: I am long puts on DIA and TLT


Investment Report – July 2011: Net Payout Yields

June was a good month for the Net Payout Yields model on a relative basis. The model outperformed the SP500 by 0.67% with a loss of 1.16% versus the 1.83% loss for the benchmark. Naturally on a absolute basis the model had a disappointing month, but it performed as expected by being less volatile than the benchmark and holding up better during the worse parts of the big drop mid month. The model

Hedging Update — Stocks

The Chicago Board Options Exchange Market Volatility Index (VIX) ticked up 1.2% Tuesday to close at 16.06. The table below shows the costs, as of Tuesday's close, of hedging 19 of the 20 of the most actively-traded stocks against greater-than-20% declines over the next several months, using the optimal puts for that.

Comparisons

For comparison purposes, I've also added the costs of hedging the SPDR S&P 500 Trust ETF (SPY), the SPDR Dow Jones Industrial Average ETF (DIA) and the Nasdaq 100-tracking ETF PowerShares QQQ Trust ETF (QQQ) against the similar declines. 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 screenshots, in this article about hedging against a US default with optimal puts on 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).

Why There Were No Optimal Puts for LVLT

In some cases, the cost of protection may be greater than the loss you are looking to hedge against. That was the case with Level 3 Communications (LVLT). As of Friday, the cost of protecting against a greater-than-20% decline in that stock over the next several months was itself greater than 20%. Because of that, Portfolio Armor indicated that no optimal contracts were found for it.

Hedging Costs as of Tuesday's close

The data in the table below is as of Tuesday's close. After the three ETFs listed for comparison purposes, the NYSE stocks are listed in order of their share volume in Tuesday's trading, with the most actively traded stock (MI) listed first; the Nasdaq stocks are listed in a similar order, with the most actively traded Nasdaq stock (SIRI) listed first.

Symbol

Name

Cost of Protection (as % of position value)

  Comparison Index ETFs  

SPY

SPDR S&P 500

1.23%**

DIA SPDR Dow Jones Industrial Avg 1.22%**
QQQ PowerShares QQQ Trust 1.98%**
  NYSE Stocks  
MI
New M&I Corporation
5.06%**
BAC Bank of America Corporation 5.91%**
ACN
Accenture, plc
2.35%**
F Ford 4.68%**
GE General Electric Company 2.68%**
C Citigroup Inc. 3.43%**
S Sprint Nextel Corporation 8.35%**
PFE Pfizer Inc. 2.31%**
WFC Wells Fargo & Co. 3.55%**
JPM JP Morgan Chase & Co. 3.27%**
  Nasdaq Stocks  
SIRI
Sirius XM Radio Inc.
11.0%**
CSCO Cisco Systems, Inc. 3.89%**
MSFT Microsoft Corporation 2.57%**
MU Micron Technologies 12.1%**
INTC Intel Corporation 2.67%**
LVLT
Level 3 Communications, Inc.
No Optimal Puts At This Threshold
BLUD
Immucor, Inc.
0.37%*
ORCL Oracle Corp. 3.12%**
YHOO
Yahoo! Inc.
5.55%**
DELL Dell Inc. 4.35%**

*Based on optimal puts expiring in December, 2011.

**Based on optimal puts expiring in January, 2012.


Hedging Update — Stocks

The Chicago Board Options Exchange Market Volatility Index (VIX) declined 2.56% Monday to close at 20.56. The table below shows the costs, as of Monday's close, of hedging 20 of the most actively-traded stocks against greater-than-20% declines over the next several months, using the optimal puts for that.

Comparisons

For comparison purposes, I've also added the costs of hedging the SPDR S&P 500 Trust ETF (SPY), the SPDR Dow Jones Industrial Average ETF (DIA) and the Nasdaq 100-tracking ETF PowerShares QQQ Trust ETF (QQQ) against the similar declines. 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 in Seeking Alpha's Investing Tools Store 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.

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 Monday's close

The data in the table below is as of Monday's close. After the three ETFs listed for comparison purposes, the NYSE stocks are listed in order of their share volume in Monday's trading, with the most actively traded stock (BAC) listed first; the Nasdaq stocks are listed in a similar order, with the most actively traded Nasda stock (MSFT) listed first.

Symbol

Name

Cost of Protection (as % of position value)


Comparison Index ETFs

SPY

SPDR S&P 500

1.42%*

DIA SPDR Dow Jones Industrial Avg 1.17%*
QQQ PowerShares QQQ Trust 1.74%*

NYSE Stocks

BAC Bank of America Corporation 7.28%**
F Ford 4.83%*
S
Sprint Nextel Corporation 6.60%**
GE General Electric Company 3.12%*
PFE Pfizer Inc. 2.43%*
JPM
JP Morgan Chase & Co.
3.86%*
WFC Wells Fargo & Co. 5.25%**
NOK Nokia Corporation 13.9%**
C Citigroup Inc. 3.90%*

Nasdaq Stocks

MSFT
Microsoft Corporation
2.62%**
CSCO
Cisco Systems, Inc. 6.11%**
INTC
Intel Corporation
4.45%**
MU
Micron Technologies
15.9%**
ORCL
Oracle Corp.
3.29%*
NVDA
NVIDIA Corporation
8.83%*
DELL
Dell Inc.
5.27%**
ALU Alcatel-Lucent 11.5%*
RIMM Research in Motion, Ltd 12.73%*
CMCSA
Comcast Corporation
4.00%**

*Based on optimal puts expiring in December, 2011.

**Based on optimal puts expiring in January, 2012.


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