A next-generation hedging algorithm
Portfolio Armor, for those who missed the post introducing it on the old blog, offers a tool to help investors hedge their stocks and ETFs with put options. For each stock or ETF he owns, an investor just enters the symbol, the number of shares he has, and the maximum downside risk he is willing to tolerate; Portfolio Armor then shows him the optimal put options to buy to get the level of protection he wants at the lowest cost.
The prime directive: being a tool, not offering advice
In some cases, the cost of protection may be higher than the loss an investor is looking to prevent. In that case, Portfolio Armor will inform the investor that no optimal options exist. Aside from that, though, Portfolio Armor will not tell a user whether he should have insurance, or how much insurance he should have (i.e., it does not offer advice). As the site notes,
Each investor is unique and one investor’s risk tolerance may differ from another’s. If you aren’t sure about what your own risk tolerance is, or about how much protection you should have, you may want to consult with a licensed or registered financial professional to discuss this.
While test-driving the site, one of the positions my technical consultant entered was a marginal example where the cost of insuring a security against his specified loss was only slightly less than the loss he was looking to prevent. He asked me if he should add a “buffer” to the site’s algorithm so that, in addition to telling the user that no optimal options exist in cases when those options cost more than the loss the user is looking to prevent, the site would also tell users that no optimal options exist when the options only cost slightly less than the loss the user is looking to prevent.
Erring on the side of the Traveler
I mentioned that I was wary of subjectively defining “slightly” in this context, and he suggested using a typical options commission as the “buffer”. In response I wrote,
Did you ever watch Star Trek, The Next Generation? Do you remember the last episode with The Traveler, the fellow with the funny-shaped forehead1 who could bend warp fields with his mind? There was a scene toward the end of the episode where all hell was breaking lose, and war was about to break out between the Federation and the Cardassians. Wesley Crusher shouted and time stopped, and then the Traveler appeared. Wesley started to describe the crisis to the Traveler, and you might have expected a deus ex machina resolution at that point, given the Traveler’s superpowers. But instead, he said, “Have faith in their abilities to solve their problems on their own.” And they did.
I think we have to err on the side of the Traveler here. I agree with you that it doesn’t make sense to buy put options to protect against a $2 loss. But I also think that the average investor will notice when the cost of his insurance is almost exactly as much as the loss he is looking to insure against, and he will think twice about buying insurance in those cases. And if he is confused, he will be able to find a licensed or registered investment adviser through the site who can help him out.
Also, one problem with building in as a buffer the cost of a typical options commission (which is a good idea, in theory) is that options commissions will vary by brokerage and by the number of contracts purchased. Another problem is this: let’s say we estimated a typical options commission and it was $20. As you know, to be conservative, Portfolio Armor calculates the cost of the options contracts at the ask. In some cases, the investor will be able to buy the options for a lower cost, i.e., some price between the bid and the ask. In those cases, the difference in cost between what he actually pays for the options and the ask price listed on the site will likely be greater than his options commissions.
Journey’s end
The first four minutes or so of this clip covers the scene described above with the Traveler:
1In hindsight, “a funny-shaped forehead” doesn’t quite narrow it down in this episode.
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