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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I wrote the two articles linked to below last month.  They proved to be good timing. After writing the second one, and noticing how optimal hedging costs on the gold-tracking ETF GLD had been climbing fast, I decided to buy puts on GLD myself, as a speculative bearish bet against it. Those puts were up 120% today.

- “Why you should consider hedging if you own gold”.

- “Gold goes parabolic, hedging costs rise”

These were the optimal puts to mentioned in that second article; the ones to hedge against a greater-than-20% drop in GLD over the next several months on 8/22:

Those puts on Friday:

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And this follow up Monday night (published yesterday), in which I noted that the hedging costs mentioned in the first article had doubled: “Gold goes parabolic, hedging costs rise“. I took that spike in hedging costs as a bearish signal, and placed a small bet against GLD yesterday, which is up about 27% so far today.

Hedging costs have continued to rise since Monday, unsurprisingly, as GLD has dropped. This was the screen print of the optimal puts Portfolio Armor presented on Monday as a hedge against a >20% drop in the gold-tracking ETF $GLD between then and mid-March:

After today’s drop in gold and GLD, the ask price on those puts has risen to $6.50.

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I met with the finance Ph.D. who devised Portfolio Armor’s algorithm yesterday to discuss some potential expansions of the algorithm. More to come on that. If you have any feature requests, feel free to mention them in the comments.

June was another record month for paid downloads of the Portfolio Armor iOS app, with an 37% increase over the number of paid downloads in May. Paid downloads in May were up 17.4% over April’s numbers. The app reached as high as #13 on AppShopper.com’s list of the top-grossing iPhone finance apps this week; as I type this, it’s currently ranked #23.

Soon I Will Be Invincible

A few months ago, I recommended a book I’d read by Neil Gaiman called American Gods. That book, apparently, is a bigger deal than I thought, as is Neil Gaiman. Cheryl got tickets to see him at the 92nd Street Y in Manhattan last week, and I went with her. Easily over a thousand fans turned out to see Gaiman, and they cheered him like he was a rock star.

The other author who interviewed Gaiman on stage at the 92nd Street Y was Lev Grossman. His name didn’t ring a bell for me at first, but Cheryl found out later that he was the twin brother of Austin Grossman, whose first novel, Soon I Will Be Invincible, was a clever, quick, and entertaining read.

Before the Gaiman event, we got ice cream from the Big Gay Ice Cream truck, whose proprietor offers some exotic takes on soft serve ice cream (my vanilla cone, for example, was topped with cayenne pepper, crushed sourdough pretzels, and chocolate sauce). Not cheap though: $11 for a cone and a small cup.

Update: Forgot to mention this, but Tom Hanks’s production company is going to produce 6 seasons of an American Gods series for HBO. Season 1 will cover the original book.

Rut-Roh for St. Joe Co. longs

I submitted an article to Seeking Alpha about this earlier today, but here’s the Bloomberg’s story on it, “St. Joe, Chairman Bruce Berkowitz Are Subject of Formal Probe by U.S. SEC”. I’m still holding the $25 strike Jan 2012 puts on JOE.

Update: Here’s my latest Seeking Alpha article on JOE.

Hedging against a failure to raise the debt ceiling

I submitted an article to Seeking Alpha about this as well, earlier today, after reading that House Majority Leader Eric Cantor has been hedging his exposure to Treasuries. I’ll post links here if and when Seeking Alpha publishes the articles, but something that surprised me about this: checking Portfolio Armor, the cost of hedging the iShares Barclays 20 Year Treasury ETF (TLT) is currently pretty low — 0.85% of position value, to hedge against a greater-than-20% drop between now and 1/20/2012.

Update: Here’s the article: “Helping House Majority Leader Eric Cantor Hedge his Treasuries Exposure”

2001: A Space Odyssey

I’ve found myself thinking more about that movie recently. I started to write a blog post about it, in which I was going to note the juxtaposition of the banal and the profound in it. Then I saw on Wikipedia that some critic had taken the same tack, except he called it the “banal and the sublime”. Maybe I’ll write that post anyway though.

The good parts of Gravity’s Rainbow

I was also thinking of writing a series of posts about the good parts of Gravity’s Rainbow, for those who don’t feel like slogging through the rest of the novel to find them.

Fulshear, Texas

I’ve noticed a number of clicks here from that small town in Texas. Sorry there haven’t been any new posts here for a while. If there’s any sort of post you’ve been looking for in particular, feel free to send me a note or leave comment about that below.

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The finance academic who developed Portfolio Armor’s algorithm successfully defended his doctoral thesis and now has his Ph.D. He and I plan to meet later this month to discuss adding the capability to Portfolio Armor to hedge short positions with calls (should be doable) and potentially adding collar capability (will require some preliminary research to determine feasibility). If we end up adding these new capabilities, I’ll have to raise prices for new subscribers to offset the development costs, but I will grandfather current subscribers at current prices.

Meet the winner of the Short Screen message boards contest

Adam Sharp, of Bearish News:

Back in April I entered a contest at ShortScreen.com. Ended up winning an iPad2!

So thanks to Dave Pinsen and the guys over there. My blogging productivity is at near-year lows, thanks to the new precious. And my 24 mo kid monopolizes it if I take it out around him. Two, and he plays Angry Birds. By himself. I’m glad I won this thing, because I probably wouldn’t have swallowed my anti-Apple pride and bought one.

News from Alloy Steel

The stock dropped 18% Wednesday on this news from the company:

Following a review of the company organization structure CEO John Cleland has departed the Company effective 27 May 2011. The Company will advise shareholders of the revised organization structure in due course.

If I didn’t own any of the stock, I’d probably buy here, but I already own plenty of AYSI, and I decided after last summer’s excitement that I wouldn’t buy any shares of it over a buck again.

In other AYSI news this week, Alloy Steel’s founder Gene Kostecki was nominated as a candidate for entrepreneur of the year for Western Australia by Ernst & Young. The E&Y profile of Kostecki included this bit about his future plans for the company:

Gene’s financial goal is to increase sales to $300 million by 2015. Having recently come off NASDAQ, he is looking to list on ASX. To this end, the company has appointed an independent chairman and board and is in the process of establishing a new corporate governance system consistent with ASX principles.

The company has just completed an Indonesian land purchase in a manufacturing estate, funded out of cash flow. Gene intends to build a factory to allow ASI to achieve its growth aspirations, which will be funded by a mix of debt and equity. He plans build up a substantial manufacturing hub in Indonesia, while maintaining his Australian operations, and using Australia as a research and development base.

Two recent Seeking Alpha articles by me

– Groupon, Grilled Cheese, and Internet Bubble 2.0

– Germany continues to outpace the U.S. in job creation

Two exits of speculative options bets this week

As I posted on Short Screen at the time, I got out of AIB puts for a 25% gain, and out of NAK puts for a 40% gain.

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TRGL versus IMO

The chart below shows the performance of TRGL and IMO from when I entered the trade on 3/31/2011 until when I exited on 4/21/2011. I started out with 24% trailing stops on both sides of this trade, but as I noted on Short Screen at the time, I tightened those trailing stops on both sides (to 8%) on 4/19. So I got stopped out of TRGL early on 4/21 — at $7.58, instead of $8.85, which is where it closed that day. Once I got stopped out of TRGL, I sold my long position in IMO. Overall, it wasn’t a bad trade: I made 3% on the long side and 30% on the short side, for a combined return of 16.5% on the combined trade.

Why TRGL popped on 4/21

The company, an oil & gas E&P with its operations in the Paris Basin, had been under a cloud as the French government considered banning shale exploration for environmental reasons. On 4/21, the company commented on an interim report about shale exploration by a French government agency, but there was nothing conclusive about that report; the pop on 4/21 looks like it was a simply a short squeeze.

Performance of TRGL from 4/21 until this week

The chart below shows how TRGL shares have done since I got stopped out on 4/21.

Why this was a missed opportunity

Because the bearish case against TRGL hadn’t materially changed on 4/21, so I should have taken advantage of the bounce and bought in-the-money puts on it then. I didn’t think of that at the time.

Buying puts on a stock after getting stopped out of a short position

The odd thing is that I did do that when I got stopped out of the short side of another market neutral trade (Short JOE, Long GTY) for a loss earlier this year. Since I thought the bearish case against JOE remained intact, I bought long-dated, in-the-money puts on it (which I’m still holding). It’s something I’ll consider going forward when I get stopped out for gains as well.

A reminder about hedging versus betting

Those puts on JOE were a speculative bet against  the stock; because of that, I bought in the money puts on it, consistent with Tim’s guidelines about buying options in Chart Your Way to Profits. That makes sense for directional bets (when you are willing to pay more to reduce the odds against your bet) but would be sub-optimal in most cases for hedging (when you want to get a certain level of protection at the lowest possible cost).

If I were hedging, I would enter the symbol of the stock or ETF I was looking to hedge in the “symbol” field of Portfolio Armor (available as a web app and as an Apple iOS app), enter the number of shares in the “shares owned” field, and then enter the maximum decline I was willing to risk in the “threshold” field. Then Portfolio Armor would use its algorithm to scan for the optimal puts to give me that level of protection at the lowest cost.

On rare occasions (I’ve seen it happen once, so far) the optimal puts Portfolio Armor presents might be in-the-money; in most cases however they will be out-of-the-money.

My most recent market neutral trade

I entered another market neutral trade last Friday, long ALB, short ADES. More details on that at the link.

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