Cushioning A Cliff Dive

Not Reading Slope Of Hope Can Be Expensive

Back on Tuesday, February 12th, hedge fund manager, market technician and proprietor of the Slope of Hope blog noted natural resources stocks were weakening and suggested shorting Cliffs Natural Resources (CLF).

The next day, Cliffs dived 20% after announcing a cut in its dividend after the close on Tuesday.

From A Mess To The Masses

The old Odd Lot Theory was based on a simple premise: the average, small investor (those who couldn’t afford round lots of shares) was usually wrong. Guess which stock Fidelity customers were buying with both hands as it dropped 20% on February 13th?

As the screen capture from Fidelity’s website that day shows, CLF was one of the most actively traded names on Fidelity’s system on February 13th — 70% of those trades were buy orders.

Hedging CLF on February 13th

At the time, I noted that, of course the best time to consider hedging a stock was before it suffered a large drop, but given the number of falling knife buyers that day — and the possibility that CLF could keep falling — I’d post a couple of optimal hedges. As Tim Knight pointed out in a follow-up post on Monday (“Cliff – The Short That Keeps Delivering“), CLF did indeed keep falling. Below are the CLF hedges I posted on February 13th, along with how those hedges have reacted as the stock has continued to tumble.

Two Ways To Hedge CLF

The first way used optimal puts*; that way had a cost, but allowed uncapped upside. These were the optimal puts, as of February 13th’s close, for an investor who was looking to hedge 1000 shares of CLF against a greater-than-20% drop between then and July 19th:

As you can see in the screen capture above, the cost of those optimal puts, as a percentage of position, was 6.93%. Note that, to be conservative, cost here was calculated using the ask price of the optimal puts; in practice an investor can often buy puts for a lower price (i.e., some price between the bid and the ask). By way of comparison, the cost of hedging the SPDR S&P 500 ETF (SPY) against the same decline, over a somewhat longer time frame (until September 20th), was 0.83% of position value.

Those Puts On March 4th

How They Cushioned The Cliff Dive

Cliffs traded at $29.29 on February 13th. An investor who owned 1000 shares and bought the optimal puts to hedge it against a >20% drop that day had $29,290 in stock and an outlay of $2,030 on the puts (again, assuming, conservatively, that he bought the puts at the ask). $29,290 + $2,030 = $31,320.

As of Monday’s close, his CLF shares were worth $23,780 and his options were worth $4,100: $23,780 + $4,100 = $27,880. So although CLF dropped about 23% from February 13th’s close to March 4th’s close, an investor who bought those puts at the close on the 13th was only down about 11% on his combined hedge + underlying stock position over the same time frame.

The Second Hedging Scenario

A CLF investor interested in hedging against the same, greater-than-20% decline between February 13th and July 19th, but who was also willing to cap his potential upside at 16% over that time frame, could have used the optimal collar** below to hedge instead.

As you can see at the bottom of the screen capture above, the net cost of this optimal collar was negative — meaning the CLF investor was getting paid to hedge in this case.

The Put Leg Of That Collar On Monday, March 4th

How That Collar Cushioned The Cliff Dive

An investor who owned 1000 shares and bought the optimal collar above to hedge it against a >20% drop that day had $29,290 in stock and an outlay of -$70 on the collar (because the income from selling the call leg slightly more than offset the cost of buying the put leg). $29,290 – $70 = $29,220.

As of Monday’s close, his CLF shares were worth $23,780 and his put options were worth $2,880: $23,780 + $2,880 = $26,660. So although CLF dropped about 23% from February 13th’s close to March 4th’s close, an investor who bought those puts at the close on the 13th was only be down about 8.8% on his combined hedge + underlying stock position over the same time frame.

More Protection Than Promised

Recall that in both hedging scenarios — the optimal put and the optimal collar — our hypothetical investors were looking to hedge against greater-than-20% declines. Because the puts in both cases had plenty of time value in addition to intrinsic value as of Monday’s close, they offered more protection than that.

*Optimal puts are the ones that will give you the level of protection you want at the lowest possible cost. Portfolio Armor 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.

**Optimal collars are the ones that will give you the level of protection you want at the lowest net cost, while not limiting your potential upside by more than you specify. The algorithm to scan for optimal collars was developed in conjunction with a post-doctoral fellow in the financial engineering department at Princeton University.

The screen captures above come from the latest build of the soon-to-come 2.0 version of the Portfolio Armor iOS app. Optimal collar capability will be available as an in-app subscription in the 2.0 version of the app.

Reining In The Risk Of A Triple-Leveraged ETF

The Downside Of Leveraged ETFs

Leveraged ETFs can add some excitement to a portfolio: bet right on underlying index, and you can earn double or triple the returns of that index. The downside of leveraged ETFs, though, is their potential downside. Consider one of the most widely-traded leveraged ETFs, the Direxion Daily Gold Miners Bull 3X Shares (NUGT): we’re just about six weeks into 2013, and unhedged NUGT longs who bought the ETF at the beginning of the year are already down more than 29%, as of Tuesday’s close.

Too Expensive To Hedge Against A >20% Drop With Optimal Puts

As we noted in a recent post, hedging a security against a greater-than-20% drop can offer a reasonable compromise between limiting downside risk and lowering the cost of hedging. Unsurprisingly for such a volatile ETF (as of Tuesday, the 52-week high and low prices on NUGT were $26.69 and $7.62, respectively), its puts are expensive. On Tuesday, NUGT was too expensive to hedge against a greater-than-20% drop using optimal puts*. That’s because the cost of hedging it against a greater-than-20% drop over the next several months was itself greater than 20% of position value.

The smallest decline threshold against which it was possible to hedge NUGT on Tuesday over that time frame was 25%. These were the optimal puts to hedge 1000 shares of NUGT against a greater-than-25% drop by September 20th, as of Tuesday’s close:

As you can see in the screen capture above, the cost of those optimal puts, as a percentage of position, was almost as high as that decline threshold: 24.05%. It’s hard to imagine any investor would want to take a 24% hit to hedge against a >25% drop.

Just as NUGT’s puts were expensive on Tuesday, though, so were its calls. By combining the right long puts and short calls on NUGT into a collar, an investor could have dramatically lowered his hedging costs.

Not Too Expensive To Hedge With Optimal Collars

A NUGT investor interested in hedging against a greater-than-20% decline between now and September 20th, but also willing to cap his potential upside at 13% over that time frame, could have used the optimal collar** below to hedge 1000 shares on Tuesday instead.

As you can see at the bottom of the screen capture above, the net cost of this optimal collar is negative — meaning the NUGT investor would be getting paid to hedge in this case, an amount equal to 6.33% of his position value.

Calculating Net Cost Conservatively

It’s worth noting, that, to be conservative, the cost of the puts above was calculated using their ask price, and, also to be conservative, the income from the calls was calculated using their bid price. Since, in practice, an investor can often buy puts for less than their ask price (i.e., some price between the bid and ask), and an investor can often sell calls for more than their bid price (again, for some price between the bid and ask), a NUGT investor opening this optimal collar on Tuesday would likely have been paid more than 6.33% of his position to do so.

Worst Case Scenario

For the purposes of this example, we’ll assume our hypothetical investor just got paid 6.33% of his position to open that collar. What’s his worst case scenario? That would be his NUGT shares dropping by more than 20%. If that happened, the investor’s losses on the ETF would be limited to 20%, but remember, he made 6.33% when he opened that collar. So, taking that into account, his worst case downside here would be a net loss of 13.67%.

Best Case Scenario

The best case scenario for an investor who opened this collar would be for NUGT to rise 13% or more. If that happened, the investor’s NUGT shares would get called away, so his upside there would be capped at 13%. But add in the 6.33% the investor made when he opened the collar, and he would have a total gain of 19.33%

*Optimal puts are the ones that will give you the level of protection you want at the lowest possible cost. Portfolio Armor 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.

**Optimal collars are the ones that will give you the level of protection you want at the lowest net cost, while not limiting your potential upside by more than you specify. The algorithm to scan for optimal collars was developed in conjunction with a post-doctoral fellow in the financial engineering department at Princeton University.

The screen captures above come from the latest build of the soon-to-come 2.0 version of the Portfolio Armor iOS app. Optimal collar capability will be available as an in-app subscription in the 2.0 version of the app.

Two Ways Of Hedging Priceline.com

Priceline.com Shares Rise But Growth Threat Remains

Shares of Priceline.com, Inc. (Nasdaq: PCLN) rose 1.81% Tuesday as its competitor Expedia (Nasdaq: EXPE) posted a 24% increase in sales. Nevertheless, headwinds remain for both companies. As Kevin Shalvey noted at Investor’s Business Daily, Ascendiant Capital Markets senior research analyst Edward Woo has warned about the growth threat posed to Priceline and Expedia by Google (Nasdaq: GOOG), whose acquisition of travel software firm ITA indicated a major move by the search engine giant into travel search and commerce.

The growth threat to Priceline by Google was also mentioned by Morgan Stanley analyst Scott Devitt when he downgraded PCLN recently, as Eric Savitz reported in Forbes last week. Devitt also highlighted the threat PCLN faced from Expedia in Europe.

For investors who own Priceline and are considering adding downside protection in light of the growth threat it faces from Google (and from its competitor Expedia), we’ll look at a couple of different ways to hedge its shares against a greater-than-20% decline between now and late July.

Why Consider Hedging Against A >20% Drop

A twenty percent decline threshold is worth considering, because it lowers the cost of hedging somewhat (all things equal, the larger the potential loss you are looking to hedge against, the less expensive it is to hedge), and because a 20% decline is not necessarily an insurmountable one. To recover from a 20% loss, an investor would need a 25% rebound in his stock. But to recover from, say, a 35% drop, would require a rebound of nearly 54%.

Two Ways To Hedge PCLN

The first way uses optimal puts*; this way has a higher cost, but allows uncapped upside. These are the optimal puts, as of Tuesday’s close, for an investor looking to hedge 100 shares of PCLN against a greater-than-20% drop between now and July 19th:

As you can see in the screen capture above, the cost of those optimal puts, as a percentage of position, is 2.68%. By way of comparison, the current cost of hedging the SPDR S&P 500 ETF (NYSE: SPY) against the same decline, over the same time frame, is 0.99% of position value.

A PCLN investor interested in hedging against the same, greater-than-20% decline between now and July 19th, but also willing to cap his potential upside at 19% over that time frame, could have used the optimal collar** below to hedge instead.

As you can see at the bottom of the screen capture above, the net cost of this optimal collar is negative — meaning the PCLN investor would be getting paid to hedge in this case.

*Optimal puts are the ones that will give you the level of protection you want at the lowest possible cost. Portfolio Armor 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.

**The algorithm to scan for optimal collars was developed in conjunction with a post-doctoral fellow in the financial engineering department at Princeton University, and is currently available on the web version of Portfolio Armor.

The screen captures above come from the latest build of the soon-to-come 2.0 version of the Portfolio Armor iOS app. Optimal collar capability will be available as an in-app subscription in the 2.0 version of the app.

Hedging a $500k Portfolio: A Step-By-Step Example

A reader recently emailed me, asking how he could hedge a “typical $500k mutual fund portfolio”. I’m going to walk through a step-by-step example of doing that in this post.

Step One: Choose A Proxy Exchange-Traded Fund

If you own a portfolio of stocks or stock funds, you can hedge that portfolio against market risk by buying optimal puts* on a suitable exchange-traded fund, or ETF. The first consideration is that the ETF will need to have options traded on it, but most of the most widely-traded ETFs do. The second consideration is that the ETF be invested in same asset class as your portfolio. Let’s assume your portfolio consists primarily of blue chip U.S. stocks. An ETF you could use as a proxy would be the SPDR Dow Jones Industrial Average (DIA), which, as its name suggests, tracks the Dow Jones Industrial Average. You could then enter its ticker symbol, DIA, in “Ticker Symbol” field in the Portfolio Armor app, as in the screen capture below.

Step 2: Pick A Number Of Shares

In order to hedge a $500k equity portfolio against market risk, you would want to hedge an equivalent dollar amount of your proxy ETF. Since DIA traded at $138.76 on Wednesday, you would simply divide your portfolio dollar amount, $500,000, by $139.76, and enter the quotient, 3603, in the “Shares Owned” field, as in the screen capture below.

Step 3: Pick a Threshold

“Threshold”, in this context, means the maximum decline in the value of your position that you are willing to risk. If you weren’t sure of that, you could click on the question mark to the right of the Threshold field above, and you’d see this explanation in the screen capture below.

What is the maximum decline you are willing to risk? Generally, the larger the decline threshold, the less expensive the hedge, and vice-versa. In some cases, a threshold that’s too small can be so expensive to hedge that the cost of doing so is greater than the loss you are trying to hedge. In a market comment in 2008, fund manager John Hussman offered a reason for considering a 20% threshold:

An intolerable loss, in my view, is one that requires a heroic recovery simply to break even … a short-term loss of 20%, particularly after the market has become severely depressed, should not be at all intolerable to long-term investors because such losses are generally reversed in the first few months of an advance (or even a powerful bear market rally).

Essentially, 20% is a large enough threshold that it reduces the cost of hedging but not so large that it precludes a recovery. So, for this example, we’ll enter 20, in the Threshold field below, and tap “done”, as in the screen capture below.

Step 4: Find the Optimal Puts

A moment after tapping “Done”, we are presented with the optimal puts. The screen capture below shows the optimal puts, as of Wednesday’s close to hedge against a greater-than-20% drop in DIA.

As you can see at the bottom of the screen capture above, the cost of this protection was only 0.37% of your position value.

How This Hedge Would Protect Your Portfolio Against Market Risk

Remember, the reason we picked DIA in this case is because our hypothetical investor’s portfolio consisted of blue chip US stocks. If those stocks drop in value due to a market decline, most likely, the Dow Jones Industrial Average will have dropped as well. And if the Dow has dropped, the ETF tracking it, DIA, will have dropped as well. If the Dow drops more than 20% — if it drops 20.5%, 30%, 40%, or even more before June 21st — the put options above will rise in price by at least enough so that the total value of a $500k position in DIA + the puts will have only dropped by 20%, in a worst-case scenario.

Put option prices can move in a nonlinear fashion, which enables a small dollar amount of them to hedge a much larger dollar value position in an underlying security. Here is an example of that nonlinearity in action: in June of 2011, I bought the optimal puts to hedge against a greater-than-20% decline in DIA over the next several months for my portfolio. Those optimal puts happened to be the $98.75 strike, December expiration puts (represented by the symbol DIA111217P00098750 in the screen capture below). On one day early that August, the Dow and DIA dropped 4.28%. On that day those optimal puts on DIA were up 74.77%.

Hedging Using A Smaller Threshold

If you want to scan for an optimal hedge using a different threshold, you can do so. All else equal, it will be less expensive to hedge against a larger decline, and more expensive to hedge against a smaller decline, but the cost of hedging against market risk is low enough right now that you might consider using a smaller threshold. Below is a screen capture of the optimal puts to hedge against a greater-than-15% decline in DIA, as of Wednesday’s close.

Hedging A Portfolio Of Stocks And Bonds

The example above is simplified in that we’ve assumed our hypothetical investor’s portfolio is entirely invested in equities. But what if he had some bonds as well? In that case, he could use a similar process to hedge his portfolio against market risk, except instead of using just one proxy ETF, he’d use one per each asset class. So, for example, if 60% of the investor’s assets were in blue chip US stocks, and 40% in investment grade corporate bonds, he might scan for optimal puts for a $300k position in DIA and then scan for optimal puts for a $200k position in the iShares iBoxx $ Investment Grade Corporate Bond ETF (LOD).

*Optimal puts are the ones that will give you the level of protection you want at the lowest possible cost. Portfolio Armor (also available as an 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.

Two Ways of Hedging NFLX

Netflix, Inc.  (NFLX), shares of which were up about 70% last week,  offers another interesting comparison of hedging with optimal puts to hedging with optimal collars.

Here are the optimal puts, as of Friday’s close, for an investor looking to hedge 10,000 shares of NFLX against a greater-than-20% drop between now and June 21:

Embedded image permalink

As you can see in the screen capture above, the cost of those optimal puts, as a percentage of position, is 13.09%.

An NFLX investor interested in hedging against the same, greater-than-20% decline over the same time frame, but also willing to cap his potential upside at 15%, could use the optimal collar below to hedge.

As you can see at the bottom of the screen capture above, the net cost of this optimal collar is negative – that means that the NFLX investor would be getting paid to hedge in this case.

The algorithm to scan for optimal collars was developed in conjunction with a post-doctoral fellow in the financial engineering department at Princeton University, and is currently available on the web version of Portfolio Armor. The screen captures above come from the latest build of the soon-to-come 2.0 version of the Portfolio Armor iOS app.  Optimal collar capability will be available as an in-app subscription in the 2.0 version of the app.

Two Ways Of Hedging ZNGA

Mobile game maker Zynga, Inc. (ZNGA) offers an interesting comparison of hedging with optimal puts to hedging with optimal collars.

Here are the optimal puts, as of Friday’s close, for an investor looking to hedge 10,000 shares of ZNGA against a greater-than-20% drop between now and June 21:

ZNGA Optimal Puts

As you can see in the screen capture above, the cost of those optimal puts, as a percentage of position, is 14.46%.

A ZNGA investor interested in hedging against the same, greater-than-20% decline over the same time frame, but also willing to cap his potential upside at 20%, could use the optimal collar below to hedge.

ZNGA Optimal Collar

As you can see at the bottom of the screen capture above, the net cost of this optimal collar is negative – that means that the ZNGA investor would be getting paid to hedge in this case.

The algorithm to scan for optimal collars was developed in conjunction with a post-doctoral fellow in the financial engineering department at Princeton University, and is currently available on the web version of Portfolio Armor. The screen captures above come from the latest build of the soon-to-come 2.0 version of the Portfolio Armor iOS app.  Optimal collar capability will be available as an in-app subscription in the 2.0 version of the app.

Follow-Up: How Three Apple Hedges Reacted To Thursday’s Drop

In a recent post (“Two Ways of Hedging Apple and Research In Motion“), we mentioned that hedge fund manager and market technician Tim Knight’s bearish November post about Apple (“How Apple Became Japan“) looked prescient. It looks even more prescient now after Apple’s post-earnings tumble. In our post, we mentioned a few different hedges on Apple. Below is a quick update of how those hedges reacted as Apple dropped more than 12% on Thursday.

February Expiration Optimal Put

This was the optimal put* we first mentioned in an August 17th tweet. This was the optimal put to hedge against a greater-than-20% drop from Apple’s share price at the time (about $648).

Feb AAPL Optimal Put Update

July Expiration Optimal Put

This was the optimal put we mentioned in our previous post on hedging AAPL, to hedge against a drop of greater-than-20% from Apple’s price at the end of last week (about $500 per share).

July AAPL Optimal Put Update

July Expiration Optimal Collar Update

And, finally, this is an update on the optimal collar** we mentioned in that previous post. This one was designed to protect against a greater-than-20% drop from its then-current market price of about $500, while capping an investor’s upside at 15%. This was a negative-cost collar, because the income from selling the calls more than offset the cost of buying the puts, so an investor opening that collar was effectively getting paid to hedge. Note that the call leg here has dropped in price, as expected. If our hypothetical investor turned bullish on Apple today, for some reason, he could buy back that call leg here for less than he sold it for, removing his upside cap.

July AAPL Collar Update

*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.

**Optimal collars are the ones that will give you the level of protection you want at the lowest net cost, while not limiting your potential upside by more than you specify. The extension to the Portfolio Armor algorithm to find optimal collars was developed by a post-doctoral fellow in the financial engineering department at Princeton University.

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