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.

Hedging Update

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Hey Fellow Slopers,

In the table below, I've updated the costs (as of Thursday's close) of hedging the Dow-, NASDAQ 100-, and S&P 500-tracking ETFs against greater-than-20% declines over the next several months, using the optimal puts, along with the costs of similarly hedging a handful of their most widely-traded components. In addition, this week I added five precious metals ETFs to the table. First, a reminder about why I've used 20% as a decline threshold, and what I mean by "optimal puts".

As I mentioned last time, the threshold I usually use when I hedge is 20% (i.e., I want protection against any decline worse than that). The idea for a 20% threshold came from a comment fund manager (and Stanford finance Ph.D.) John Hussman made 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).

"Optimal puts" are the ones that will give you the level of protection you want at the lowest possible cost. With Portfolio Armor (available as a web app, and an 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. candidate to sort through and analyze all of the available puts for your position, scanning for the optimal ones.

What jumped out at me in putting together this table was the cost of hedging GLD against a greater-than-20% decline over the next several months: 0.31%. With the cost of downside protection this low, if you're long GLD, you might want to consider hedging it here, even if you're bullish on it in the mid- to long-term.

Symbol

Name

Cost of Protection (as % of Position value)

Widely-Traded Stocks

INTC

Intel

3.06%**

CSCO

Cisco Systems

3.09%**

MSFT

Microsoft

2.%**

ORCL

Oracle

2.07%*

BAC

Bank of America

6.02%***

F

Ford

4.32%*

GE

GE

2.35%*

PFE

Pfizer

1.51%*

WFC

Wells Fargo

4.71%**

T

AT&T

1.55%**

AA

Alcoa

3.57% **

Major Index ETFs

QQQ

PowerShares QQQ Trust

1.48%*

SPY

SPDR S&P 500

1.04%*

DIA

SPDR Dow Jones Industrial Average

0.82%*

Precious Metals ETFs

GLD

SPDR Gold Trust

0.31%*

SLV

iShares Silver Trust

4.48%**

DBP

PowerShares DB Precious Metals

1.4%**

SGOL

ETFS Physical Swiss Gold Shares

1.09%*

SIVR

ETFS Physical Silver Shares

3.82%*

*Based on optimal puts expiring in September, 2011

**Based on optimal puts expiring in October, 2011

***Based on optimal puts expiring in November, 2011

Disclosure: I'm holding some puts on DIA.

Plan Not to Panic

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Hey fellow Slopers,

Initially, I wasn't planning on posting this here, as some of you will find it a little basic. But I received an e-mail over the weekend from a Slope lurker and self-described beginner with questions, so I thought other beginners lurking here might find some value in it. The only new info in the post below for the rest of you will be this: the cost of hedging against a >20% drop in DIA over the next several months dropped to 0.84% today (Monday).

First though, a quick, unrelated note: In the comments here on Friday, I mentioned a stock that someone had posted about on Short Screen the night before, PUDA, was plummetting. Trading in its shares was halted Monday. On to today's post:

—————————————————————————————————————————

"Plan not to panic" next time your stock portfolio drops 40%. That was hedge fund manager Joel Greenblatt’s advice for retail investors in a column on his Magic Formula investing site last year. So what did Greenblatt do when Mike Burry, a hedge fund manager Greenblatt’s Gotham Capital invested with, was down 18% in 2006 (after several years of spectacular returns), due to early, illiquid bets against subprime mortgages — bets that Burry wanted to hold to fruition? From p.190 of Michael Lewis’s book, "The Big Short,"

Immediately … Gotham Capital threatened to sue him.

…

What distinguished Gotham was that their leaders flew out from New York to San Jose and tried to bully Burry into giving them back the $100 million they had invested with him. In January 2006 Gotham’s creator, Joel Greenblatt, had gone on television to promote a book and, when asked to name is favorite "value investors," had extolled the virtues of a rare talent named Mike Burry. Ten months later he traveled three thousand miles with his partner, John Petry, to tell Mike Burry he was a liar and to pressure him into abandoning the bet Burry viewed as the single shrewdest of his career.

Flash forward to the end of 2007. Mike Burry’s hedge fund is up about 130%, as his shorts on subprimes pay off. From p. 223 of "The Big Short,"

Still he [Burry] heard not a peep from his investors.

…

To his founding investor, Gotham Capital, he shot off an unsolicited e-mail that said only, "You’re welcome." He’d already decided to kick them out of the fund, and insist that they sell their stake in his business. When they asked him to suggest a price, he replied, "How about you keep the tens of millions you nearly prevented me from earning for you last year and we call it even?"

If the billionaire professional investor Joel Greenblatt — who, due to his funds’ short positions isn’t as exposed to market risk as long-only, un-hedged Magic Formula investors — has trouble stomaching an 18% decline, why would he expect retail investors to suck it up when they get hammered by a 40% drop?

Note that I’ve only singled out Greenblatt here because of the juxtaposition between his advice and his actions in that case; he’s got plenty of company in telling regular equity investors to just suck it up next time the market tanks. About the only form of risk management that gets mentioned frequently in popular investment columns is diversification. Diversification has a significant limitation though.

Diversifying among a basket of different stocks reduces idiosyncratic (or, stock-specific) risk, but not market risk. An example of idiosyncratic risk would be if news broke that the CFO of a company you owned stock in had been cooking the books. In that case, you’d obviously be better off if you’d had your money diversified among five or ten different stocks instead of having all of your money in that one, shady stock. When the market tanks though, nearly all stocks get hammered. That’s market risk.

In fact, not only does diversifying among a bunch of different stocks not protect you from market risk, but diversifying among different, putatively non-correlating asset classes (e.g., stocks, bonds, commodities) doesn’t always help you either. The problem there is that when the worst happens, correlations go to one: almost everything tanks. For example, when the stock market crashed in 2008, so did commodities, corporate bonds, and other asset classes (about the only asset that did well was U.S.Treasuries, but that doesn’t mean that they’ll do well next time the market tanks).

So how can a long investor protect himself against market risk?  He can hedge. One way to do that is by buying puts on ETFs that track market indexes. Here are a few examples of market indexes and the ETFs that track them:

  • The Dow Jones Industrial Average: SPDR Dow Jones Industrial Average ETF DIA
  • The S&P 500: SPDR S&P 500 ETF SPY
  • The Nasdaq 100: PowerShares ETF QQQ

You can find a list of put options available on those index ETFs by clicking on the "options" tab on their quote pages on sites such as Yahoo! Finance, Morningstar, or Google Finance. For example, here’s the list of options available for DIA, the ETF that tracks the Dow (scroll down on that page for the put options). As you can see from clicking that last link, there’s a whole lot of them. Which one should you buy if you want to hedge?

First, you have to ask yourself how much of a market decline you’re willing to stomach (all things equal, the bigger the decline you’re willing to tolerate, the cheaper it will be to hedge against — similar to how car insurance will be cheaper when you have a higher deductible). The threshold I usually use when I hedge is 20% (i.e., I want protection against any decline worse than that). The idea for a 20% threshold came from a comment fund manager (and Stanford finance Ph.D.) John Hussman made 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).

Once you know how much risk you’re willing to risk (whether it’s a 20% decline or some other threshold), you’ll want to find the optimal puts — the ones that will give you the level of protection you want at the lowest possible cost. That part can be a little complicated. Portfolio Armor was built to make it simpler.

With Portfolio Armor (available as a web app and an 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 accept (your threshold), and then the app uses an algorithm developed by a finance Ph.D. candidate to scan for the optimal puts.

A couple of reasons (both of which we've mentioned here before) why this might be a good time to consider hedging:

  1. + With stock market volatility declining recently, it has gotten cheaper to hedge. For example, as of Friday, the cost of hedging against a >20% decline in the Dow-tracking ETF DIA over the next several months was 0.84% of your position
  2. + Prudence may be warranted with the end of the second round of the Fed’s quantitative easing (QE2) scheduled for the end of June. In a recent Bloomberg TV appearance, economist David Rosenberg (formerly, Merrill Lynch’s chief North American economist) noted that there’d been an 88% correlation between the movements in the Fed balance sheet and the direction of the S&P 500 over the last two years (Rosenberg did think there would be a QE3, but probably not until next year).

Disclosure: I am long puts on DIA

Hedging Update (by Dave Pinsen)

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Hey Fellow Slopers,

In our last hedging post, we looked at the cost of hedging the Dow (via the SPDR Dow Jones Industrial Average ETF DIA) and its components. This time, we'll compare the current costs of hedging the Dow with the costs of hedging the NASDAQ 100 (via the PowerShares ETF QQQ) and the S&P 500 (via the SPDR S&P 500 ETF SPY) and a few of their most widely-traded components. First, a quick recap of why an investor might consider hedging now. 

We mentioned a couple of reasons last week:

1) Hedging had gotten cheaper recently, as volatility has declined. Volatility has come down a little more since our last post, with the VIX closing at 16.90 on April 6th, not far from its 52-week low of 14.86.

VIX

2) Prudence may be warranted with the end of QE2 scheduled for the end of June. Last week we quoted David Rosenberg, chief economist at Gluskin Sheff & Associates (formerly chief North American economist at Merrill Lynch, who noted that there had been an 88% correlation between the movements in the Fed balance sheet and the direction of the S&P 500 over the last two years. Rosenberg thought there would be a QE3, but maybe not until next year. I didn't catch it until this week, but apparently Marc Faber told Bloomberg last week that he also expects that there'll be a QE3, but not right away. Faber also said that the Fed might welcome a stock correction as a rationale for implementing QE3 ( at about 3:30 of this clip). 

With that covered, below is a table showing the current costs of hedging the Dow, NASDAQ, and S&P 500 tracking ETFs and a few of their components, against greater-than-20% declines over the next several months using the optimal puts (I used the Portfolio Armor iOS app to pull up the optimal puts for these securities, but you can also use the web app versions of Portfolio Armor). First though, a reminder of what "optimal" means in this context, and also an explanation of why I picked 20% decline thresholds.

The optimal put options are the ones that will give an investor the level of protection he wants at the lowest possible cost. Portfolio Armor uses a proprietary algorithm developed by an all-but-dissertation finance Ph.D. candidate to find the optimal contracts to hedge stocks and ETFs.

You can enter any percentage you like for a threshold when using Portfolio Armor(the the higher the percentage, the greater the chance you will find optimal puts for your position). The idea for a 20% threshold comes 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).

In the table below, unless marked with an asterisk, the optimal put option contracts for the security expire in October; one asterisk indicates the options expire in September; two asterisks indicate that the options expire in November.

Disclosure: I'm holding a few puts on DIA.

Symbol

Name

Cost of Protection (as % of Position value)

INTC

Intel

2.81%

CSCO

Cisco Systems

2.1%

MSFT

Microsoft

2.29%

ORCL

Oracle

2.23%*

BAC

Bank of America

4.66%**

F

Ford

4.39%*

GE

GE

2.09%*

PFE

Pfizer

1.72%*

WFC

Wells Fargo

2.96%

T

AT&T

1.48%

AA

Alcoa

4.8%

QQQ

PowerShares QQQ Trust

1.34%*

SPY

SPDR S&P 500

1.06%*

DIA

SPDR Dow Jones Industrial Average

0.81%*

 

*Based on optimal puts expiring in September, 2011.

**Based on optimal puts expiring in November, 2011.

Hedging the Dow

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Hey fellow Slopers,

In our last post on hedging, we looked at hedging Internet stocks and ETFs. In this post, we'll look at hedging the Dow (via the SPDR Dow Jones Industrial Average ETF SPY) and its components. But first, it's worth asking why an investor might consider hedging now. Two reasons come to mind:

1) Hedging has gotten cheaper recently, as volatility has declined. As of March 28th, the VIX was back below 20, after spiking up to around 30 earlier this month, a few trading days after the 2011 Tōhoku earthquake and tsunami hit Japan.

 

2) Prudence may be warranted with the end of QE2 scheduled for the end of June. On Bloomberg TV Monday, David Rosenberg, chief economist at Gluskin Sheff & Associates (formerly chief North American economist at Merrill Lynch noted the correlation between the Fed's quantitative easing and the direction of U.S. stocks during the current cyclical bull market off of the March '09 lows: 

It’s one thing to have a fundamentally-based bull market: they tend to last for many, many years. But liquidity: it’s there one minute and can be gone the next minute […] In the past two years there’s been an 88% correlation between the movements in the Fed balance sheet and the direction of the S&P 500. If the Fed embarks on some exit strategy in the second half of the year, much like they did for a temporary period last year, it will be interesting to see how the market responds once QE2 runs its course if QE3 doesn’t follow suite in June or July

Rosenberg went on to say that he thought there would be a QE3, but that it might not come until this time next year.

With that in mind, below is a table showing the current costs of hedging each Dow component, and the Dow-tracking ETF DIA, against greater-than-20% declines over the next several months using the optimal puts (I used the Portfolio Armor iPhone app to pull up the optimal puts for these securities, but you can also use the web app versions of Portfolio Armor). First though, a reminder of what "optimal" means in this context, and a note about the time frames involved. The optimal put options are the ones that will give an investor the level of protection he wants at the lowest possible cost. Portfolio Armor uses a proprietary algorithm developed by an all-but-dissertation finance Ph.D. candidate to find the optimal contracts to hedge stocks and ETFs.

In his research, the Ph.D. candidate who developed the algorithm found that options with approximately 6 months to expiration tend to offer the best combination of liquidity and cost, so those are the puts for which Portfolio Armor's algorithm aims. When puts with about six months to expiration aren't available, Portfolio Armor searches for slightly longer or shorter times to expiration. In the table below, unless marked with an asterisk, the optimal put option contracts for the security expire in September; one asterisk indicates the options expire in August; two asterisks indicate that the options expire in October. All things equal, one would expect options with less time to expiration to be less expensive, and ones with more time to expiration to be more expensive.

Disclosure: I have a limit order in to buy the optimal puts on DIA referred to above.

Hedging the Bursting of Internet Bubble 2.0

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Hey fellow Slopers,

A conversation I had earlier this week with an NYC-based Internet entrepreneur prompted me to think about the current Internet bubble and how one might hedge against it with protective puts. More about that below, but first a quick reminder: if you want to enter the contest I mentioned in a post earlier this month to win an iPad 2 for posting a comment about a stock, there's one week left to do that. More details at that link. On to today's post.

The entrepreneur I alluded to above was Jesse Middleton, co-founder of GetMinders1 and WeWork Labs. Prior to founding GetMinders, Jesse was the director of IT at LivePerson, Inc. (LPSN). When we met for dinner Tuesday night, Jesse brought up South by Southwest, which he attended. That reminded me of this tweet of his from the conference last week:

Our conversation about that tweet, in turn, got me thinking about ways one could hedge against a bursting of the New Internet Bubble using protective puts. Consider a business owner whose revenues were closely tied to the fortunes of privately-held, venture-backed start-ups in the sector: he couldn’t hedge against a collapse in those companies directly, but he could buy put protection against a big correction in some publicly traded securities in the Internet sector, as an indirect hedge. A couple of ideas came to mind:

1) Buying puts on Internet ETFs.

Judging by their top 10 holdings, the First Trust Dow Jones Internet Index ETF (FDN), is more diversified than the Merrill Lynch Internet HOLDRs ETF (HHH), which has nearly 40% of its assets in Amazon.com (AMZN). Below are the put option contracts Portfolio Armor presented as the optimal ones to hedge against greater-than-25% declines in these ETFs, but first a quick reminder about what “optimal” means in this context: The optimal put option contracts are the ones that will give you the precise level of protection you want at the lowest possible cost. Portfolio Armor uses a proprietary algorith developed by a finance Ph.D. candidate to find the optimal contracts to hedge stocks and ETFs.

 

 

One note about the wide difference between the “initial cost” and “current value” Portfolio Armor shows for the optimal put option contract for FDN: to be conservative, Portfolio Armor uses the “ask” to calculate initial cost (“current value” is based on the “last” price). In practice, an investor might be able to buy the contracts for less than the ask price (i.e., some price between the bid and ask). Going by the ask price though, the cost of hedging against a greater-than-25% drop in FDN is pretty high: 6.72% of the position value. The cost of a similar hedge on HHH is 2.25% of position value.

2) Buying puts on a basket of Internet stocks.

The first candidate I thought for this basket was Open Table (OPEN), based partly on something Howard Lindzon wrote about the company on his blog last fall:

Nobody liked OpenTable.com when they went public in 2009. It has only tripled in 2010. OpenTable.com has the distribution with the restaurateurs and the brand name with the consumer. It took 10 plus years to get there. With $80 million in sales and $1.5 billion in market cap most smart people I know think it’s overvalued. That was 30 points ago. OpenTable.com will buy any talent and feature it needs. It is a much smarter way to own these fancy new start-ups and that is what the big money is doing. These momentum spurts can last much longer than you think. They are not that complicated. It helps to understand what’s happening in the start-up world at any given time and that’s why I love the intersection where I sit.

The “intersection” Lindzon referred to to there is between his roles as an investor in publicly-traded companies, and as an entrepreneur and angel investor in start-ups. Other candidates I thought of were Amazon.com (AMZN), Netflix (NFLX), Salesforce.com (CRM), and Internet infrastructure plays Akamai Technologies (AKAM) and Juniper Networks (JNPR). Of those, AMZN, OPEN, and CRM had the highest valuations on a PEG basis, ranging from 2.01 for AMZN to 3.08 for CRM. Portfolio Armor presented these as the optimal put option contracts to hedge against greater-than-25% declines in these stocks:

 

 

The cost of hedging against greater-than-25% drops in these stocks is, respectively, 3.17% of position value for AMZN, 4.79% for CRM, and a lofty 11.56% for OPEN — an average cost of 6.5% of position value for the basket.

Hedging in this manner with the stocks or ETFs above isn't cheap right now. All else equal though, it would of course, be cheaper to hedge with the same stocks and ETFs if you used a higher threshold for declines, e.g., hedging against a greater-than-30% decline instead of a greater-than-25% decline.

1Getminders sends automated health-related reminders via phone or text. I mentioned to Jesse that the web version of Portfolio Armor sends out automated notifications as well, via e-mail (the lower priced iPhone app version does not). I received this one today:

Dear Dave Pinsen:

Your puts on the position(s) below are going to expire within a week. You may want to buy new puts on the security before the current puts expire. Please log into Portfolio Armor to determine the optimal puts to buy based on the level of protection you specify.

SPY110319P00094000 – 2011-03-30

QQQQ110319P00039000 – 2011-03-30

If you wish to turn off email notifications, please sign in to Portfolio Armor and click manage account.