Steam Catapult » Economics

Hedging Costs for Gold-Tracking ETF Jump after Fed Chairman’s Testimony

David Pinsen — Thu, 01 Mar 2012 05:05:30 +0000

We tweeted this before Bernanke’s testimony Tuesday:

Cheap to hedge $GLD against a greater than 20% drop between now & September – 0.8%. Longs should consider it. twitter.com/PortfolioArmor…

— Portfolio Armor (@PortfolioArmor) February 29, 2012

Hedging costs had jumped 46% for GLD by the end of the day, as we noted in this Seeking Alpha article.

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Hedging two banks exposed to the European Sovereign Debt Crisis

David Pinsen — Thu, 01 Dec 2011 07:28:52 +0000

“Days to save the Eurozone”, then the big rally

A couple of days before Wednesday’s coordinated central bank action goosed global markets, Wolfgang Münchau wrote in his FT column (“The Eurozone has only days to avoid collapse”) that if the European summit on December 9th didn’t lead to an ambitious three part plan to save the Euro (an ECB backstop + a timetable for a Eurobond + plus an agreement on a fiscal union) the Eurozone risked collapse:

I am hearing that there are exploratory talks about a compromise package comprising those three elements. If the European summit could reach a deal on December 9, its next scheduled meeting, the eurozone will survive. If not, it risks a violent collapse. Even then, there is still a risk of a long recession, possibly a depression.

With that in mind during Wednesday’s rally, I took a look at this Business Insider slideshow of the banks most exposed to the European sovereign debt crisis. Of the ones traded in the US, Banco Santandar, S.A.(STD) and Royal Bank of Scotland (RBS) were among the most exposed, with 11.8% and 12.2%, respectively, of total bank value exposed to European sovereign risk.

Hedging banks exposed to the European Sovereign Debt Crisis

Even after rallying over 11% on the day, RBS in particular was still ludicrously expensive to hedge — too expensive to hedge against any decline smaller than 42%. Seeing how high its optimal hedging cost was, I put in a limit order to buy a few puts on RBS. I didn’t get a fill on them though. The table below shows the costs, as of Wednesday’s close, of hedging RBS and STD against greater-than-42% declines over the next several months, using optimal puts.

Comparisons

For comparison purposes, I’ve also added the cost of hedging the SPDR S&P 500 Trust ETF (SPY), and, because Tim Knight mentioned its significance in a post on Wednesday (“Naughtvember”), the Direxion Daily Bear 3X Energy ETF (ERY) against the same decline. First, a reminder about what optimal puts are, and why I’ve used 42% as a decline threshold here; then, a screen capture showing the optimal puts to hedge RBS.

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” is the maximum decline you are willing to risk in the value of your position. 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’m using 42% as a decline threshold here because, as of Wednesday’s close, RBS was too expensive to hedge against any smaller decline threshold.

The optimal puts for RBS

Below is a screen capture showing the optimal put option contract to buy to hedge 100 shares of RBS against a greater-than-42% drop between now and March 16, 2012. A note 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.

Hedging costs as of Wednesday’s close

The hedging costs below are as of Wednesday’s close and are presented as percentages of position value.

Symbol	Name	Hedging Cost
STD	Banco Santandar, S.A.	13.4%**
RBS	Royal Bank of Scotland	15.7%*
ERY	Direxion Daily Bear 3X Energy	17.8%***
SPY	SPDR S&P 500 Trust	0.78%**

*Based on optimal puts expiring in May, 2012

**Based on optimal puts expiring in June, 2012

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

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Me in the FT, and a little more AYSI

David Pinsen — Sun, 23 Oct 2011 06:33:49 +0000

– I neglected to mention this at the time, but I picked up a few more shares of AYSI on Thursday at $0.75. No new news on it, but when I saw it hit .75 I entered a limit order which was partially filled. This was my most recent Seeking Alpha article on the company, which sums up the current situation.

– The FT published this letter of mine on Saturday, Questionable statistics on [green] job creation.

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Earthquakes and optimal put options

David Pinsen — Wed, 24 Aug 2011 02:56:31 +0000

Earthquake hits NYC, BAC blamed.

After a rare East Coast earthquake shook New York City Tuesday, this was one of a number of tweets I saw blaming the tremor on Bank of America (another suggested what we felt was BAC’s implosion).

Bank of America is one of the top holdings of Bruce Berkowitz’s Fairholme Fund, and when Berkowitz spoke at the American Association of Individual Investors in Manhattan earlier this summer, it was the stock he spent the most time talking about.

Meet the domestic stock fund manager of the decade

That’s the title Morningstar gave Bruce Berkowitz (pictured above) earlier this year. Berkowitz is a value investor who eschews technical analysis, by the way. This was his one reference to technical analysis during his AAII presentation in June:

Have patience, because it’s impossible to time it right. (I’ve tried everything – chicken bones, technical analysis). I always seem to suffer from premature accumulation – I buy too soon, and keep buying.

But, as I mentioned above, Berkowitz spent most of his time talking about BAC then. The steep drop in Bank of America shares since prompted me to look back at its relative hedging costs over time, as I’ve tracked them in posts about hedging the Dow.

High optimal hedging costs as a red flag?

Since late March, I’ve updated the hedging costs of each Dow component, and the SPDR Dow Jones Industrial Average ETF (DIA), using optimal puts, seven times. In 5 of those 7 posts, starting with this one published on April 21, “Hedging the Dow, an Update“, BAC had the highest hedging costs of any Dow component. Let’s take a look at the table from that article published on April 21, but first, a quick reminder about optimal puts.

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 — 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.

Hedging costs of the Dow and its components as of April 20th

The table below shows the costs, as of April 20, 2011, of hedging each Dow component, and the Dow-tracking ETF (DIA), against greater-than-20% declines over the next several months.

Symbol	Name	Cost of Protection (as % of Position value)
(AA)	Alcoa Inc. Common Stock	3.19%**
(AXP)	American Express	2.13%**
(BA)	Boeing	3.04%***
(BAC)	Bank of America	4.89%***
(CAT)	Caterpillar	4.39%***
(CSCO)	Cisco Systems	2.01%**
(CVX)	Chevron	1.47%*
(DD)	E.I. du Pont de Nemours	2.87%**
(DIS)	Walt Disney	1.97%**
(GE)	General Electric	1.91%*
(HD)	Home Depot	2.53%***
(HPQ)	Hewlett-Packard	2.79%***
(IBM)	International Business Machines	1.20%**
(INTC)	Intel	1.91%**
(JNJ)	Johnson & Johnson	0.7%**
(JPM)	JP Morgan Chase	1.57%*
(KFT)	Kraft Foods	0.72%*
(KO)	Coca-Cola	1.00%***
(MCD)	McDonald’s	0.68%*
(MMM)	3M	1.95%**
(MRK)	Merck	1.41%**
(MSFT)	Microsoft	2.17%**
(PFE)	Pfizer	1.47%*
(PG)	Procter & Gamble	0.86%**
(T)	AT&T	1.43%**
(TRV)	Travelers	1.69%**
(UTX)	United Technologies	2.15%***
(VZ)	Verizon Communications	1.53%**
(WMT)	Wal-Mart Stores	0.75%*
(XOM)	Exxon Mobil	1.39%**
(DIA)	SPDR Dow Jones Industrial Average ETF	0.67%*

*Based on optimal puts expiring in September, 2011.

**Based on optimal puts expiring in October, 2011.

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

Volatility and hedging costs on April 20th versus August 23rd

The VIX closed at 15.07 on April 20th, prompting me to note in my article then that,

Volatility can spike quite quickly though, so if you are considering hedging, you may want to consider doing so while volatility remains relatively low.

Note how low the costs of DIA against a >20% drop were back then — 0.67% of your position, using optimal puts expiring in September. Below is a screen shot showing the costs of hedging against a >20% drop in DIA between now and March, as of today, with the VIX at 36.27.

The highest hedging costs in the Dow on April 20th

The cost of hegding BAC against a >20% drop over the next several months was 4.89%, the highest of any Dow component on April 20th.

Four Dow stocks with the highest hedging costs on April 20th

Disregarding the differences in options expiration dates, BAC was one of four stocks in the table above for which the costs of hedging against >20% declines were greater than 3%. The others were Alcoa (AA), Boeing (BA), and Caterpillar (CAT). The Google finance chart below shows how they’ve performed since April 20.

Four Dow stocks with the lowest hedging costs on April 20th

Disregarding the differences in options expiration dates, there were four stocks in the table above for which the costs of hedging against >20% declines was less than 1%: Wal-Mart Stores, Inc. (WMT), Kraft Foods Inc. (KFT), Procter & Gamble Company (PG), and McDonald’s Corporation (MCD). The chart below shows how they’ve performed since April 20.

Are optimal hedging costs a tell?

It’s an interesting hypothesis, but I would want to see a lot more data on it before using it as a basis for picking stocks. Fortunately, we may see that data soon. A quant on the Portfolio Armor team just started a postdoctoral fellowship at a particularly well-funded university where he’ll have access to extensive historical options data. He’s got another Portfolio Armor-related study lined up first (on the best times to hedge), but he may add this one to the queue. I’ll post a follow up here after if he finds conclusive data, one way or another, about this.

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Living in interesting times

David Pinsen — Sun, 07 Aug 2011 20:25:42 +0000

Last week was an interesting week for stocks, and, if the performance of one foreign stock market that was open today is any guide, tomorrow may be interesting too. Here’s a snapshot of how stocks did on Israel’s Tel Aviv stock exchange this Sunday:

Last week was also the best week yet for subscriptions to Portfolio Armor and downloads of the Portfolio Armor iOS app.

My two latest Seeking Alpha articles:

“After the Downgrade: Hedging US Treasuries”

“Lessons from Thursday’s Market Meltdown“

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Hedging Update — Post Debt Ceiling Edition

David Pinsen — Thu, 04 Aug 2011 05:50:38 +0000

Hedging costs after the debt deal

Last week, with the debt ceiling negotiations dragging on, we looked at the costs of hedging a handful of equity index, gold-, Treasury bond-, and dollar index-tracking ETFs. Below is a snapshot showing the current hedging costs of the same basket of ETFs.

Hedging against a >30% correction in stocks

The table below shows the costs, as of Wednesday’s close, of hedging the same 5 equity index ETFs against greater-than-30% corrections over the next several months, using optimal puts.

Hedging against a >15% correction in bonds, gold, and the dollar

The table also shows the costs of hedging the same gold-, U.S. dollar-, and Treasury Bond-tracking ETFs against greater-than-15% declines over the next several months using optimal puts. First, a quick reminder about what optimal puts are, and a note about costs, followed by a couple of observations.

Optimal puts

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 our previous post, “Hedging against a Dollar Drop“. A note about costs

To be conservative, Portfolio Armor calculates hedging costs using the ask price of the optimal puts. In many cases, you may be able to buy the puts for a lower cost (between the bid and the ask prices).

Hedging Costs as of Wednesday’s Close

Symbol	Name	Cost of Protecting against >30% Decline, as % of position

	Equity Index ETFs
QQQ	PowerShares QQQ Trust	1.23%*
SPY	SPDR S&P 500	0.98%*
DIA	SPDR Dow Jones Industrial Avg	0.87%*
EFA	iShares MSCI EAFE Index	2.62%*
EEM	iShares MSCI Emerging Markets	1.61%*

Symbol	Name	Cost of Protecting against a >15% Decline, as % of position

	U.S Dollar ETF
UUP	PowerShares DB US Dollar Index	0.38%*
	U.S. Treasury Bonds
TLT	iShares Barclays 20+ Yr Treas	1.47%*
	Gold
GLD	SPDR Gold Trust	1.50%*

Observations

Two observations jump out here. The first is that hedging costs of TLT have dropped considerably — 1.47% for about 7.5 months of protection this week versus 1.49% for about 5.5 months of protection last week. That makes sense intuitively, considering that the risk of near term default, however remote it was, is off the table now (though the risk of a downgrade in medium term isn’t).

The second observation is that the costs of hedging GLD relative to TLT have jumped this week: 1.50% for GLD versus 1.47% for TLT this week, compared to 0.64% for GLD versus 1.49% for TLT last week.

*Based on optimal puts expiring in March, 2012.

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Hedging Update — Default Watch Edition

David Pinsen — Fri, 29 Jul 2011 13:08:50 +0000

Credit Suisse on the consequences of a default

On Thursday, Credit Suisse’s global strategy team said that a U.S. default was still unlikely. However, they predicted that if the U.S. did default, stocks would suffer a 30% drop.

Hedging against a >30% correction in stocks

With that in mind, the table below shows the costs, as of Thursday’s close, of hedging 5 equity index ETFs against greater-than-30% corrections over the next six months, using optimal puts.

Hedging against a >15% correction in bonds, gold, and the dollar

The table also shows the costs of hedging gold-, U.S. dollar-, and Treasury Bond-tracking ETFs against greater-than-15% declines over the same time period using optimal puts. First, a quick reminder about what optimal puts are, and a note about costs.

Optimal puts

A note about costs

Hedging Costs as of Thursday’s Close

Symbol	Name	Cost of Protecting against >30% Decline, as % of position

	Equity Index ETFs
QQQ	PowerShares QQQ Trust	1.17%*
SPY	SPDR S&P 500	0.73%*
DIA	SPDR Dow Jones Industrial Avg	0.62%*
EFA	iShares MSCI EAFE Index	1.57%*
EEM	iShares MSCI Emerging Markets	1.17%*

Symbol	Name	Cost of Protecting against a >15% Decline, as % of position

	U.S Dollar ETF
UUP	PowerShares DB US Dollar Index	0.14%*
	U.S. Treasury Bonds
TLT	iShares Barclays 20+ Yr Treas	1.49%*
	Gold
GLD	SPDR Gold Trust	0.64%*

*Based on optimal puts expiring in January, 2012

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