Hedging the Most Actively Traded ETFs

05/02/2013 8:00 am EST

Focus: OPTIONS

In a sign of continued market complacency, four out of five of the most active ETFs remain inexpensive to hedge, writes David Pinsen of ETFguide.com.

ETFs 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 (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 (SPY)
iShares MSCI Emerging Index Fund (EEM)
iPath S&P 500 VIX Short-Term Fund (VXX)
iShares Russell 2000 Index Fund (IWM)
iShares MSCI Japan Index Fund (EWJ)

Below, we'll look at two ways to hedge the last of those ETFs, iShares MSCI Japan IndexFund (EWJ), 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 late September.

  1. 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 1,000 shares of iShares MSCI Japan Index Fund against a greater-than-20% drop between now and September 20:

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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%.

  1. 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 hedge instead.

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  1. 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.

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*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 PhD 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.

By David Pinsen of ETFguide.com

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