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.

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

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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.

*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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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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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

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 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

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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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

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 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 Thursday’s Close

*Based on optimal puts expiring in January, 2012

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The Intrade prediction market enables participants to bet on whether Congress will approve an increase in the U.S. debt ceiling to $15.1 trillion on or before three dates: July 31st, August 31st, and September 30th. As of Tuesday evening, these were the chances of debt ceiling deals by those respective dates:

• July 31st: 16.2% chance of a deal raising the debt ceiling to $15.1 trillion
• August 31st: 75% chance of raising the debt ceiling by that much
• September 30th: an 88.9% chance of raising the debt ceiling by that much

Unfortunately, Intrade doesn’t offer a market for betting on whether a debt ceiling deal will be reached by August 2nd, the putative deadline.

Breaching the debt ceiling need not lead to an imminent default

If Congress can’t come to a deal raising the debt ceiling in time, the U.S. government will not be able to borrow to pay all of its obligations, but that doesn’t mean this will necessarily lead to an imminent default. The government could instead prioritize payments so that holders of Treasury securities get their interest payments as scheduled, while withholding payment from other parties (e.g., by furloughing some Federal workers, or by delaying some transfer payments).

Nevertheless, a failure of Congress to reach agreement on raising the debt ceiling would be inauspicious for holders of Treasury bonds. Another point to consider is that, even if a debt ceiling deal is reached, U.S. debt may still be downgraded at some point, which could lead to forced selling by funds which are required to own only AAA-rated bonds.

Hedging against a failure to raise the debt ceiling

In a post elsewhere earlier this month (“Helping House Majority Leader Hedge His Treasuries Exposure“), we noted reports that the House Majority Leader held “up to $15,000 in shares of the 2x levered ProShares Trust Ultrashort 20+ Year Treasury ETF (TBT)”, an amount, we suggested, was probably too low to provide much of a hedge for his exposure to Treasuries.

A more precise way to hedge

As we mentioned in a previous post, precision is one of the advantages of using optimal puts, rather than inverse ETFs, to hedge:

• Precision. Say you own 824 shares of Exxon Mobil, and you’d like to know how to hedge that position against a greater-than-17% loss. Using Portfolio Armor (available as a web app and as an Apple iOS app), you could simply enter “XOM” in the symbol field, “824″ in the number of shares field, and “17%” in the threshold field, and then Portfolio Armor would use its algorithm to scan for the optimal puts to give you that level of protection at the lowest cost.¹

The example above mentions a stock, but as we noted in that post earlier this month, Rep. Cantor could find optimal puts on the U.S. Treasury bond-tracking ETF, iShares Barclays 20+ Year Treasury Bond (TLT), as a proxy for his exposure to Treasury bonds, in the same way.

Hedging costs as of Friday’s close

The table below shows the costs, as of last Friday’s close, of hedging against greater-than-15% and -20% declines, respectively, in TLT until January 20th, 2012.

Hedging costs as of Tuesday’s close

The table below shows the costs, as of Tuesday’s close, of hedging greater-than-15% and -20% declines, respectively, in TLT until January 20th, 2012. Note that the costs are still relatively low, but have increased since Friday.

*Based on optimal puts expiring in January, 2012.

¹In that case, Portfolio Armor would round down the number of shares 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 eight of the put option contracts that would slightly over-hedge the 800 shares they cover, so that the total value of your 824 shares would be protected against a greater-than-17% loss.

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