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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The company previously announced its annual meeting would be held this Friday. Whether it’s related to that or not, volume in the company’s shares was about 40x higher than normal today. As I mentioned in this post in October, I had added a few shares at $0.75. That was the first time I had added shares since the company was trading in the .40s last year. I haven’t bought our sold any shares since October.

Shareholder Questions for AYSI Management, 4 November 2011

1) At the beginning of the year, the company announced the hiring of a new CEO, and the addition of new board members, including a new chairman. That chairman, CEO, and an additional director have since departed. Can you offer any elaboration on why they departed, particularly after so little time? Is the company looking for new CEO, chairman or director candidates currently, or is it content with the current management/board structure?

2) In responses to shareholder questions in August of last year, the company said,

We are dealing with new technology that has required numerous adjustments to our manufacturing process (to improve efficiencies and quality) which has led to downtime, limiting our capacity.

Was this new technology related to the company’s thicker Super Arcoplate? Has the number of adjustments required diminished, or is this still limiting your capacity?

3) Can you offer any clarification or update on the company’s previously announced plans to expand its manufacturing capacity? Initially, the company discussed building additional mills in Western Australia, beyond the current two; later, the company announced it was purchasing a much larger property in Indonesia. The company announced at the beginning of this year that the Indonesian purchase had been completed. Has the company started building new manufacturing capacity there? If not, why?

4) The fixed asset balance continues to grow. Is this related to developments in Indonesia?

5) Operating expenses were significantly higher in this third quarter than previously, approximately 3 times as high as last year and $300,000 higher than last quarter. It’s mentioned in the release that it’s “due to increasing administration resources and associated costs”. Does the company anticipate operating at these elevated levels going forward? Are these expenses related to Indonesia at all (or just Australia)? Any one-time items related to the departed executives?

6) Inventory balances continue to grow. Are these finished goods inventories? Are they related to specific orders that will be shipped?

7) Has the company explored a sale? Bradken has shown it is willing to consolidate smaller players in the industry and is willing to pay a healthy multiple to do so. At 2.5x sales, or approximately what Bradken paid in its last 2 acquisitions, the company is valued at $60.0 million, or 4x the company’s current valuation.

In the article announcing he was awarded Entrepreneur of the Year by Ernst & Young, Gene Kostecki said he wanted to list the company on the Australian Stock Exchange at some point. Does the company have a time frame in mind for this? Would it also keep a US listing of some kind (whether on the Pink Sheets, or elsewhere)?

9) Is the company concerned about the political situation in Australia (such as calls for a carbon tax)?

10) Is the company concerned about the possibility of a “hard landing” in China in the near term leading to a drop-off in demand for iron ore? Is the company hedging against this possibility in some way?

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

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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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As you know, the time decay is given by the Greek “theta”… the problem is that to compute an option’s theta you need a model (Black-Scholes, or some alternative), which goes against the whole premise of Portfolio Armor:  it is model-free and relies on no parametric assumptions [so there's no chance of model errors].

Here he notes that you don’t need a model to figure out the time value on an option:

We can figure out the time value on any option without a model:  it is the difference between the market price and the intrinsic value, where the latter is Max{(S-K),0} for calls and Max{(K-S),0} for puts.

And then here’s his epiphany to use a little calculus and discrete math to time the roll of the options before theta burn kicks in:

We can look at the discrete-time differential (approximation of the first derivative) of the time-value component and try to find the point before time-decay is accelerated (the second derivative) [...].  Once that trigger is hit, you can start emailing out reminders to users that they may want to roll their protection.

I think this feature is pretty exciting. We’re planning to add it in Q1 of next year.

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