We’ve mentioned in the past how diversification alone doesn’t hedge against market risk, and how hedging can. If you are looking to hedge against a greater-than-20% drop in the Dow Jones Industrial Average over the next several months, this is the current optimal put for that, as calculated by Portfolio Armor:
A couple of notes to bear in mind about the cost of that put:
1) To be conservative, the algorithm calculated the cost based on the ask price of the put. In practice, you can often by a put option for less (i.e., some price between its bid and ask price).
2) You can potentially recoup some of this cost by selling the put before its time decay accelerates. Portfolio Armor’s head quant has sketched out a way to alert an investor to exactly when an option’s time decay accelerates, using a bit of calculus and discrete math, but we are still refining and testing that sell-timing feature. We plan to have it launched this quarter.
Given the continuing uncertainty related to Europe, I will probably buy optimal puts on DIA or another market index-tracking ETF soon, as a hedge against systemic, or market risk. But rather than buying one today, I’ll probably wait for a day when the indexes are in the green, and then run a fresh scan for the optimal puts and buy those.