In a post Wednesday morning (“High-Yield Long Idea Idea Continues Strong”), Tim Knight noted the continued strong performance of his long position in the SPDR Barclays High Yield Bond ETF JNK. Back in August, I looked at the cost of hedging JNK, but I thought it might be worth taking another look after seeing Tim’s post. It turns out JNK is pretty inexpensive to hedge right now. The table below shows the cost, as of Wednesday’s close, of hedging it against a greater-than-20% drop over the next several months.

A Comparison

For comparison purposes, I’ve added six of the most actively traded ETFs to the table. First, a reminder about what optimal puts are, and a note about decline thresholds; then, a screen capture showing the optimal puts to hedge JNK.

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 position, 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.

The Optimal Puts for JNK

Below is a screen capture showing the optimal put option contract to buy to hedge 100 shares of JNK against a greater-than-20% drop between now and June 15th. 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 (the same is true of the other names in the table below).

Hedging Costs as of Wednesday’s Close

The data below is as of Wednesday’s close, and is presented as percentages of position values.

*Based on optimal puts expiring in June

**Based on optimal puts expiring in July

***Based on optimal puts expiring in August

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I noted that warning for investors in Sears (SHLD) in this tweet on December 18th:

Looks like a red flag for $SHLD longs. MT @portfolioarmor Hedging Bruce Berkowitz stks.co/1avF $AIG $BAC $C $BAM $CIT $BRK.B $JOE

— David Pinsen (@dpinsen) December 18, 2011

And then on Tuesday of this week, SHLD fell out of bed, dropping 27% in one day on news that the company was closing 100+ stores following awful Christmas season sales.

The left side of this chart reminds me of the rock in Close Encounters

Update:

Congrats to NFC champs #Giants! Enter coupon code NFCCHAMPS for a 15% discount on @PortfolioArmor this week: portfolioarmor.com/join-now $$

— Portfolio Armor (@PortfolioArmor) January 23, 2012

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A booth at the Skylark Diner

In a post this fall (“New Features and Things to Come”), I mentioned a few projects that were in the works for Portfolio Armor:

Things to come

A quant on the Portfolio Armor team, a post doctoral fellow at Princeton University, is conducting R&D on the first two features below now. I hope to have them added by the end of this quarter, and the third feature sometime in the first quarter of next year.

• Optimal call options to hedge short positions.
• Optimal collars to hedge long positions, while offsetting the cost of protective puts.
• Dynamic, optimized when-to-sell alerts for call and put options.

All of those features will be as easy to use as the rest of Portfolio Armor, with all the calculations kept in the background, as usual. But if you like math, and you want a sneak peak at the thinking behind the third feature, here’s an excerpt from our Princeton quant’s e-mail about his epiphany about this.

It turned out that our quant ran into a couple of conceptual stumbling blocks while conducting R&D on the second one of those features, optimal collars. After exchanging a series of emails on it, I suggested we meet for lunch at the Skylark Diner, which we did yesterday. Using some non-academic pragmatism, I helped him surmount the conceptual stumbling blocks. He left with a blueprint for how to tackle the problem sketched out over a few legal pad pages.

Meeting in person: still the most effective social medium.

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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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That presented something of a challenge, as we’ve got new features in the works for the web version of Portfolio Armor, and I wanted to get the word out about them to those who’ve already downloaded the iOS app. In surfing the web, I came across a blog post that mentioned a couple of books on marketing iOS apps, so I looked for them at my local Barnes & Noble, in the hopes they might offer an idea or two. I remembered something Mark Cuban wrote years ago:

I would continuously search for new ideas. I read every book and magazine I could. Heck, 3 bucks for a magazine, 20 bucks for a book. One good idea that lead to a customer or solution and it paid for itself many times over.

Skimming through Book #1 at the store, I found nothing useful in it. Book #2 looked detailed enough that I decided to buy it (I make a point of buying stuff whenever I go to Barnes & Noble. I’d hate to see them go the way of Borders). Most of it turned out to be stuff that was obvious or irrelevant to me, but there was one interesting idea in the book I had never thought of: using the boot up screen of an app as billboard. So that’s what we did as part of version 1.5 of the app, which was approved by Apple and released last weekend:

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More functionality isn’t always better

Last week, a developer/entrepreneur (and MBA, as his email signature advertised) asked me to look at his iPhone finance app. He had heard about Portfolio Armor, and mentioned that his app “covered the full spectrum of corporate finance, including options”. So I checked it out, and indeed it did include a standard options calculator. It also included mortgage, college finance, and about 20 other calculators. His app was packed with so many different tools that it was nearly 10 times the size of Portfolio Armor — almost 7MB.

Pick one problem and solve it

I hadn’t recalled seeing the developer’s app before on AppShopper’s ranking of top-200 grossing finance apps; I would have noticed, too, since I bookmark that list ranked by price, and, at $49.99, the developer’s app would have been one of only a handful priced higher than Portfolio Armor. Also, at $49.99, one sale would be more than enough to put his app on that top-200 list for a day. That I can’t recall ever seeing his app on the list in the last several months suggest he hasn’t had any sales of it during that time. That got me thinking about why some iPhone owners have been buying Portfolio Armor but not his app. I boiled the answer down to 140 characters last week:

Easier said than done

Easier said than done, obviously, and even if you accomplish that, marketing your app is another challenge (something I’m still trying to master). But I think that’s the heart of it.

All things excellent are as difficult as they are rare

If the way which I have pointed out as leading to this result seems exceedingly hard, it may nevertheless be discovered. Needs must it be hard, since it is so seldom found. How would it be possible, if salvation were ready to our hand, and could without great labour be found, that it should be by almost all men neglected? But all things excellent are as difficult as they are rare.

– Benedict Spinoza, from his Ethics, Book 5

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——————————————————————————————————————–

As you may have noticed, it’s been several months since I’ve sent out an e-mail about a market neutral trade.

Another way to limit systemic risk

During that time, I’ve been focused on another strategy to limit systemic risk: hedging with optimal put option contracts (as a quick reminder, optimal put option contracts are the ones that will give you the level of protection you specify at the lowest cost. Portfolio Armor uses an algorithm developed by a finance Ph.D. to scan for them).

Back in April, I mentioned a couple of reasons why that looked like a good time to hedge equities. Most recently, on Seeking Alpha, I made a similar suggestion about hedging Treasury bonds. My continuing theme has been to consider hedging opportunistically, when it is relatively cheap to do so, and to use Portfolio Armor to get the precise level of protection you want at the lowest cost.

We’re recently made some upgrades to Portfolio Armor, so in this e-mail I wanted to give you an update on those, along with a preview of what we’ve got planned for the future, followed by a special offer.

New features

• Quicker to use. After we noticed that about 90% of users were entering their decline thresholds as percentages, we made that the default, so you no longer need to enter a “%” sign (you can still use a dollar amount, by entering a “$” before the number).
• Another way to look at cost: Cost as % of position is automatically calculated.
• Exportable: You can now download your optimal contracts to a spreadsheet with a click of your mouse.

Things to come

A quant on the Portfolio Armor team, a post doctoral fellow at Princeton University, is conducting R&D on the first two features below now. I hope to have them added by the end of this quarter, and the third feature sometime in the first quarter of next year.

• Optimal call options to hedge short positions.
• Optimal collars to hedge long positions, while offsetting the cost of protective puts.
• Dynamic, optimized when-to-sell alerts for call and put options.

All of those features will be as easy to use as the rest of Portfolio Armor, with all the calculations kept in the background, as usual. But if you like math, and you want a sneak peak at the thinking behind the third feature, here’s an excerpt from our Princeton quant’s e-mail about his epiphany about this.

Sincerely,

David Pinsen
Portfolio Armor

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