Hedging the Dow

Weak ISM numbers and progress toward a debt ceiling deal

The Dow closed down 0.09% Monday, as concerns about weak ISM Manufacturing Index numbers weighed on the market, despite progress toward a debt ceiling deal. The Chicago Board Options Exchange Market Volatility Index (VIX) declined 6.3%, to 23.66, on the day.

Hedging the Dow

The table below shows the costs, as of Monday's close, of hedging each Dow component, and the Dow-tracking ETF (DIA), against greater-than-20% declines over the next several months, using optimal puts. First, a reminder about what optimal puts mean in this context, why I've used 20% as a decline threshold.

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 in Seeking Alpha'sInvesting Tools Store and as an Apple (AAPL) 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). 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.

Decline Thresholds

You can enter any percentage you like for a threshold when using Portfolio Armor (the higher the percentage though, the greater the chance you will find optimal puts for your position). The idea for a 20% threshold comes, as I've mentioned before, from a comment fund manager John Hussman made in a market commentary in October 2008:

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. When hedging, cost is always a concern, which is where optimal puts come in.

A Step by Step Example

You can find a step by step example of finding optimal puts for a security, with screen shots, in this recent Seeking Alpha article, "Hedging against a 50% Market Drop".

How Costs Are Calculated

To be conservative, Portfolio Armor calculated the costs below based on the ask prices of the optimal put options. In practice, though, an investor may be able to buy some of these put options for less (i.e., at a price between the bid and the ask).

Hedging Costs as of Monday's Close

The data in the table below is as of Monday's close.

Symbol	Name	Cost of Protection (as % of Position value)
(AA)	Alcoa Inc. Common Stock	3.86%*
(AXP)	American Express	3.24%*
(BA)	Boeing	3.60%**
(BAC)	Bank of America	8.05%**
(CAT)	Caterpillar	4.32%**
(CSCO)	Cisco Systems	4.11%*
(CVX)	Chevron	3.32%***
(DD)	E.I. du Pont de Nemours	2.56%*
(DIS)	Walt Disney	3.33%*
(GE)	General Electric	5.23%***
(HD)	Home Depot	3.62%**
(HPQ)	Hewlett-Packard	3.49%**
(IBM)	International Business Machines	1.37%*
(INTC)	Intel	3.01%*
(JNJ)	Johnson & Johnson	1.07%*
(JPM)	JP Morgan Chase	4.62%***
(KFT)	Kraft Foods	2.18%***
(KO)	Coca-Cola	0.93%**
(MCD)	McDonald's	2.14%***
(MMM)	3M	2.32%*
(MRK)	Merck	3.26%*
(MSFT)	Microsoft	2.09%*
(PFE)	Pfizer	3.37%*
(PG)	Procter & Gamble	0.96%*
(T)	AT&T	1.80%*
(TRV)	Travelers	1.56%*
(UTX)	United Technologies	2.94%**
(VZ)	Verizon Communications	1.53%*
(WMT)	Wal-Mart Stores	2.79%***
(XOM)	Exxon Mobil	1.52%*
(DIA)	SPDR Dow Jones Industrial Average ETF	1.97%***

*Based on optimal puts expiring in January, 2012.

**Based on optimal puts expiring in February, 2012.

***Based on optimal puts expiring in March, 2012.

Disclosure: I am long puts on DIA as a hedge.