Continuing Signs of Market Complacency
In indications of continuing market complacency, four of the five
most actively traded
on Friday were quite inexpensive to hedge against significant
declines over the next several months. The one exception was the
iPath S&P 500 VIX Short-Term Futures ETF
(NYSEARCA:VXX), but given its historical performance (down 98.85%
over the last five years, as of Friday's close), that shouldn't
come as any surprise. In order of their trading volumes on Friday,
these were the most active ETFs:
SPDR S&P 500
iShares MSCI Emerging Index Fund
iPath S&P 500 VIX Short-Term Fund
iShares Russell 2000 Index Fund
iShares MSCI Japan Index Fund
Below, we'll look at two ways to hedge the last of those ETFs,
iShares MSCI Japan Index Fund, and then we'll look at the costs of
hedging the other ETFs in a similar way.
Two Ways of Hedging
iShares MSCI Japan Index Fund
Below are two ways for an iShares MSCI Japan Index Fund long to
hedge 1000 shares against a greater-than-20% drop between now and
The first way uses optimal puts.* This way allows uncapped upside,
but it is more expensive. These were the optimal puts, as of
Friday's close, for an investor looking to hedge 1000 shares of
iShares MSCI Japan Index Fund against a greater-than-20% drop
between now and September 20:
As you can see at the bottom of the screen capture above, the cost
of this protection, as a percentage of position value, was 1.04%.
An iShares MSCI Japan Index Fund investor interested in hedging
against the same, greater-than-20% decline between now and mid late
September, but also willing to cap his potential upside at 20% over
that time frame, could have used the optimal collar** below to
As you can see at the bottom of the screen capture above, the net
cost of this collar, as a percentage of position value, is 0.69%.
Note that, to be conservative, the cost of both hedges was
calculated using the ask price for the optimal puts and the put leg
of the optimal collar, and the bid price of the call leg of the
optimal collar. In practice, an investor can often buy puts for
some price less than the ask price (i.e., some price between the
bid and ask) and sell calls for some price higher than the bid
price (i.e., some price between the bid and the ask).
Hedging Costs for All of the ETFs Mentioned Above
The table below shows the costs, as of Friday's close, of hedging
the ETFs mentioned above in a similar manner as iShares MSCI Japan
Index Fund above -- first, with optimal puts against a >20% drop
over the next several months; then (where possible), with optimal
collars against the same percentage drop over the same time frame,
while capping the potential upside at 20%. There were no optimal
collars available for the first two ETFs as of Friday's close,
given these parameters.
* Optimal puts are the ones that will give you the level of
protection you want at the lowest possible cost.
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
Portfolio Armor iOS app.
Editor's note: This story by David Pinsen originally appeared
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