Slope of Hope Blog Posts

Slope initially began as a blog, so this is where most of the website’s content resides. Here we have tens of thousands of posts dating back over a decade. These are listed in reverse chronological order. Click on any category icon below to see posts tagged with that particular subject, or click on a word in the category cloud on the right side of the screen for more specific choices.

Bull Market in Skittishness

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More and more lately, I'm seeing stocks put on these huge intraday reversals, which is bound to be infuriating to bulls and bears alike who are getting stopped out of positions only to see them move the other way minutes later. It happened to me last week with symbol ABC, but a couple of stocks that I do not trade caught my eye which had this happen to them big-time.

They are shown below. These two tickers, NLY and AGNC, apparently are a couple of mREIT issues that got completely spooked at the prospect (no matter how remote) of a U.S. default. These things plunged something like 20% at the opening bell, only to completely reverse by day's end. Except for the handful of people that can claim to have bought at the open, just about everyone associated with instruments undergoing such short-term turmoil would have become unnerved (and/or stopped out).

I point this out only to say that, with all the cross-currents swirling around us, trying to make a profit trading seems harder than ever, at least if you're the responsible sort who likes to have stop-loss orders protecting your positions. Be careful out there!

0801-NLY

0801-AGNC

Hedging Update — Default Watch Edition

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Credit Suisse on the consequences of a default

On Thursday, Credit Suisse's global strategy team said that a U.S. default was still unlikely. However, they predicted that if the U.S. did default, stocks would suffer a 30% drop.

Hedging against a >30% correction in stocks

With that in mind, the table below shows the costs, as of Thursday's close, of hedging 5 equity index ETFs against greater-than-30% corrections over the next six months, using optimal puts.

Hedging against a >15% correction in bonds, gold, and the dollar

The table also shows the costs of hedging gold-, U.S. dollar-, and Treasury Bond-tracking ETFs against greater-than-15% declines over the same time period using optimal puts. First, a quick reminder about what optimal puts are, and a note about costs.

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 on the web, and as an Apple 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 – you can enter any percentage you like, but the larger the percentage, the greater the chance there will be optimal puts available for the position). 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. 

A note about costs

To be conservative, Portfolio Armor calculates hedging costs using the ask price of the optimal puts. In many cases, you may be able to buy the puts for a lower cost (between the bid and the ask prices).

Hedging Costs as of Thursday's Close

Symbol

Name

Cost of Protecting against >30% Decline, as % of position

Equity Index ETFs

QQQ

PowerShares QQQ Trust

1.17%*

SPY

SPDR S&P 500

0.73%*

DIA

SPDR Dow Jones Industrial Avg

0.62%*
EFA iShares MSCI EAFE Index 1.57%*
EEM iShares MSCI Emerging Markets 1.17%*
Symbol Name Cost of Protecting against a >15% Decline, as % of position
U.S Dollar ETF
UUP PowerShares DB US Dollar Index 0.14%*
U.S. Treasury Bonds
TLT iShares Barclays 20+ Yr Treas 1.49%*

Gold

GLD

SPDR Gold Trust

0.64%*

*Based on optimal puts expiring in January, 2012

Costs of Hedging Treasury Bond Exposure Still Low, but Rising

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The chances of a debt ceiling deal

The Intrade prediction market enables participants to bet on whether Congress will approve an increase in the U.S. debt ceiling to $15.1 trillion on or before three dates: July 31st, August 31st, and September 30th. As of Tuesday evening, these were the chances of debt ceiling deals by those respective dates:

  • July 31st: 16.2% chance of a deal raising the debt ceiling to $15.1 trillion
  • August 31st: 75% chance of raising the debt ceiling by that much
  • September 30th: an 88.9% chance of raising the debt ceiling by that much

Unfortunately, Intrade doesn't offer a market for betting on whether a debt ceiling deal will be reached by August 2nd, the putative deadline.

Breaching the debt ceiling need not lead to an imminent default

If Congress can't come to a deal raising the debt ceiling in time, the U.S. government will not be able to borrow to pay all of its obligations, but that doesn't mean this will necessarily lead to an imminent default. The government could instead prioritize payments so that holders of Treasury securities get their interest payments as scheduled, while withholding payment from other parties (e.g., by furloughing some Federal workers, or by delaying some transfer payments).

Nevertheless, a failure of Congress to reach agreement on raising the debt ceiling would be inauspicious for holders of Treasury bonds. Another point to consider is that, even if a debt ceiling deal is reached, U.S. debt may still be downgraded at some point, which could lead to forced selling by funds which are required to own only AAA-rated bonds.

Hedging against a failure to raise the debt ceiling

In a post elsewhere earlier this month ("Helping House Majority Leader Hedge His Treasuries Exposure"), we noted reports that the House Majority Leader held "up to $15,000 in shares of the 2x levered ProShares Trust Ultrashort 20+ Year Treasury ETF (TBT)", an amount, we suggested, was probably too low to provide much of a hedge for his exposure to Treasuries.

A more precise way to hedge

As we mentioned in a previous post, precision is one of the advantages of using optimal puts, rather than inverse ETFs, to hedge:

  • Precision. Say you own 824 shares of Exxon Mobil, and you'd like to know how to hedge that position against a greater-than-17% loss. Using Portfolio Armor (available as a web app and as an Apple iOS app), you could simply enter "XOM" in the symbol field, "824" in the number of shares field, and "17%" in the threshold field, and then Portfolio Armor would use its algorithm to scan for the optimal puts to give you that level of protection at the lowest cost.1

The example above mentions a stock, but as we noted in that post earlier this month, Rep. Cantor could find optimal puts on the U.S. Treasury bond-tracking ETF, iShares Barclays 20+ Year Treasury Bond (TLT), as a proxy for his exposure to Treasury bonds, in the same way.

Hedging costs as of Friday's close

The table below shows the costs, as of last Friday's close, of hedging against greater-than-15% and -20% declines, respectively, in TLT until January 20th, 2012.

Symbol

Name

Decline Threshold

 Cost as % of Position
TLT iShares Barclays 20+ Year Treasury Bond 15% 1.22%*

TLT

iShares Barclays 20+ Year Treasury Bond

20%

 0.66%*

Hedging costs as of Tuesday's close

The table below shows the costs, as of Tuesday's close, of hedging greater-than-15% and -20% declines, respectively, in TLT until January 20th, 2012. Note that the costs are still relatively low, but have increased since Friday.

Symbol

Name

Decline Threshold

 Cost as % of Position
TLT iShares Barclays 20+ Year Treasury Bond 15% 1.48%*

TLT

iShares Barclays 20+ Year Treasury Bond

20%

 0.77%*

*Based on optimal puts expiring in January, 2012.

1In that case, Portfolio Armor would round down the number of shares you entered to the nearest hundred (since one put option contract represents the right to sell one hundred shares of the underlying security), and then present you with eight of the put option contracts that would slightly over-hedge the 800 shares they cover, so that the total value of your 824 shares would be protected against a greater-than-17% loss.

A Bearish Speculative Options Bet

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In previous posts, I've mentioned a few guidelines I'd been keeping in mind when making speculative options buys (the first three of which are mentioned in Tim's book, Chart Your Way to Profits):

  • + Start small (since options often expire worthless).
  • + Avoid out-of-the-money-options (instead, try to get ones with some intrinsic value).
  • + Avoid nearby expiration dates (to avoid theta burn and give positions more time to work out).
  • + Buy options at a discount to model estimates of their fair market value.

I'd been making occasional bullish and bearish bets to increase the chances that some bets will make money whatever direction the market takes over the next several months, but held off when the VIX was over 20. With the VIX closing at 17.56 Thursday, I screened for some bets and placed a small limit order on one. More on that below, but first, a recap of my M.O. here, and a reminder about the difference between speculative options buying and hedging.

Looking for Speculative Options Bets

For the bearish bets, I’ve been starting by scanning for relatively lightly-traded (average daily volume over the last month of < 200k shares), optionable stocks that look weak technically and fundamentally. The idea behind looking for relatively thinly-traded stocks is that the options traded on them are more likely to be thinly-traded, which increases the chances that they might be inefficiently priced. Then I look for in-the-money puts on them several months out, and compare the current bid-ask prices for them with the estimated fair market value of them via the Black-Scholes model.

If I find one where the most recent bid is significantly below the Black-Scholes fair market value estimate, I’ll place a small limit order for it, with the limit price set at a ~20%+ discount to the fair market value estimate.

For the bullish bets, I’ve been doing the reverse: Scanning for stocks that look strong technically and fundamentally, and looking for in-the-money calls priced below the Black-Scholes estimates of their fair market value.

Examples

Prior to Thursday, I used this method to purchase puts on The St. Joe Company (JOE), Northern Dynasty Minerals, Ltd. (NAK), Motricity, Inc. (MOTR), Neutral Tandem Inc. (TNDM), Midas Group, Inc. (MDS), BioCryst Pharmaceuticals (BCRX), Omeros Corporation (OMER), Citi Trends, Inc. (CTRN); and calls on Honda Motor Co Ltd. (HMC), Hitachi, Ltd. (HIT), Coherent, Inc. (COHR), IXYS Corporation (IXYS), II-VI Incorporated (IIVI), ASM International N.V. (ASMI) and Superior Industries, International, Inc. (SUP). I noted these purchases (and sales, in the case of the ones I've exited already — NAK, MOTR, HMC and HIT) at the time on the Short Screen message boards.

Hedging vs. Betting

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. Since I’m making a directional bet in the cases below, though, and not hedging, I bought slightly in-the-money options. This 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). There's a step by step example of that in this article.

A Bearish Bet

School Specialty, Inc.(SCHS) is provides supplemental educational products and equipment for the pre-kindergarten to twelfth grade market in the United States and Canada.

SCHS

Short Screen shows an Altman Z"-Score of -2.19 for SCHS (recall that scores of 1.1 and lower indicate financial distress, according to the model).

SCHS closed at $12.81 Thursday. At that price, the estimated fair market value of its $15 strike, February 2012 puts, according to the Black-Scholes model, was $3.72. The bid-ask on those puts was $2.65-$3.50. I put in a limit order for them at $2.95.

Hedging Update — Stocks

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Bank of America (BAC) was the most actively traded NYSE stock Tuesday (as it was last week), but after posting its 90 cent per share Q2 loss Tuesday, the costs of hedging it have gone up. The table below shows the costs, as of Tuesday's close, of hedging BAC and 19 of the other most actively-traded stocks against greater-than-20% declines over the next several months, using the optimal puts.

Comparisons

For comparison purposes, I've also added the costs of hedging the SPDR S&P 500 Trust ETF (SPY), the SPDR Dow Jones Industrial Average ETF (DIA), the Nasdaq 100-tracking ETF PowerShares QQQ Trust ETF (QQQ), and the U.S. Treasury Bond tracking ETF iShares Barclays 20+ Year Treasury Bond ETF (TLT) against the similar declines. First, a reminder about what optimal puts mean in this context and 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 on the web and as an Apple 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 academic to sort through and analyze all of the available puts for your position, scanning for the optimal ones (there's an example of this, with screenshots, in this article about hedging against a US default with puts on TLT).

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.

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 Tuesday's close

The data in the table below is as of Tuesday's close. After the four ETFs listed for comparison purposes, the NYSE stocks are listed in order of their share volume in Tuesday's trading, with the most actively traded stock (BAC) listed first; the Nasdaq stocks are listed in a similar order, with the most actively traded Nasdaq stock (SIRI) listed first.

Symbol

Name

Cost of Protection (as % of position value)
  Comparison Index ETFs  

SPY

SPDR S&P 500

1.53%*
DIA SPDR Dow Jones Industrial Avg 1.40%*
QQQ PowerShares QQQ Trust 2.11%*
TLT iShares Barclays 20+ Year Treas 0.61%
  NYSE Stocks  
BAC Bank of America Corporation 7.94%*
WFC Wells Fargo & Co. 3.66%*
S Sprint Nextel Corp. 5.51%*
F Ford 3.67%*
GE General Electric Company 3.12%*
HK Petrohawk Energy Corporation 0.78%*
MGM MGM Resorts International 9.19%*
JPM JP Morgan Chase & Co. 3.64%*
PFE Pfizer, Inc. 3.11%*
C Citigroup Inc. 4.52%*
  Nasdaq Stocks  
SIRI Sirius XM Radio Inc. 10.4%*
MSFT Microsoft Corporation 2.94%*
NWSA News Corporation 6.33%*
CSCO Cisco Systems, Inc. 4.09%*
INTC Intel Corporation 3.38%*
MU Micron Technologies 13.8%*
YHOO Yahoo! Inc. 4.11%*
ORCL Oracle Corp. 3.65%*
DELL Dell, Inc. 4.02%*
AAPL Apple, Inc. 2.80%*

*Based on optimal puts expiring in January, 2012.

Disclosure: I am long puts on DIA and TLT