4 Small Caps That Bucked The Market Friday: A Look At Hedging Them

June 1, 2012  |  includes: HL, IWM, MCP, NG, WEN

Weak Jobs Data Sinks Stocks; Small Caps Hit Harder

May's jobs report, released on Friday morning, was much worse than expected, showing 69,000 new jobs created last month, versus the median projection of 150,000 new jobs. That news weighed on stocks Friday, with the broader market, as measured by the S&P 500 Index, dropping 2.46% on the day, closing at 1278.04. Small caps fared worse, with the Russell 2000 Index dropping 3.20%, to close at 737.42.

A handful of small caps bucked the broader market downtrend on Friday. Among optionable small caps with market caps between $500 million and $2 billion, approximately twenty names advanced on the day. In this post, we'll look at the hedging costs of the four most actively-traded of those small caps that posted gains on Friday. Of those four, two mining stocks, NovaGold Resources, Inc. (NG) and Molycorp, Inc. (MCP), were extremely expensive to hedge. Recall that we have observedexamples of high optimal hedging costs presaging poor performance. The table below shows the costs, as of Friday's close, of hedging four of the small caps that posted gains on Friday against greater-than-23% declines over the next several months, using optimal puts.

A comparison

For comparison purposes, I've added the iShares Russell 2000 Index ETF (IWM). First, a reminder about what optimal puts are, and a note about the 23% decline threshold I've used here; then, a screen capture showing the optimal puts to hedge the comparison ETF, IWM.

About optimal puts

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 Ph.D. to sort through and analyze all of the available puts for your position, scanning for the optimal ones.

Decline thresholds

In this context, "threshold" refers to the maximum decline you are willing to risk in the value of your position in a security. You can enter any percentage you like for a decline threshold when scanning for optimal puts (the higher the percentage though, the greater the chance you will find optimal puts for your position).

Often, I use 20% thresholds when hedging equities, but two of these stocks were too expensive to hedge using 20% thresholds (i.e., the cost of hedging them against a greater-than-20% drop was itself greater than 20%, so Portfolio Armor indicated that no optimal contracts were found for them). There were optimal contracts available for all of these names using a decline threshold of 23%, so that's the threshold I've used below.

The optimal puts to hedge IWM

Below is a screen capture showing the optimal put option contract to buy to hedge 100 shares of the Russell 2000-tracking ETF IWM against a greater-than-23% drop between now and December 30th. A note about these optimal put options and their cost: to be conservative, the app calculated the cost based on the ask price of the optimal puts. In practice, an investor can often purchase puts for a lower price, i.e., some price between the bid and the ask (the same is true of the other names in the table below).

Hedging Costs as of Friday's close

The hedging costs below are as of Friday's close, and are presented as percentages of position values. The stocks are listed in descending order of their share volumes on Friday, with the most actively traded stock,Wendy's Co. (WEN), listed first. As we noted above, some of these names have extremely high hedging costs. If you own these stocks as part of a diversified portfolio, and are content to let that diversification ameliorate your stock-specific risk, but are still concerned about market risk, you may want to consider buying optimal puts on an index-tracking ETF (such IWM) instead, as a way to hedge your market risk.

Symbol	Name	Hedging Cost
WEN	Wendy's Co.	7.49%**
HL	Hecla Mining Co.	13.7%*
NG	NovaGold Resources, Inc.	22.3%*
MCP	Molycorp, Inc.	22.7%*
IWM	iShares Russell 2000	4.05%*

*Based on optimal puts expiring in December

**Based on optimal puts expiring in January

By David Pinsen

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.