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Two Ways of Hedging Apple and Research In Motion

January 20, 2013 | About:
Back in November, when Apple was about 40 points higher than it is now, hedge fund manager and market technician Tim Knight wrote what now looks like a prescient post about how its stock's best days were behind it (See How Apple Became Japan). Here's how Tim concluded that post:
:

As for the stock price, I suspect it'll resemble the Nikkei chart found way above, although perhaps not as dramatically. I imagine AAPL will be in the low 400s next year and will meander around relatively trendlessly for years to come. Its multi-thousand percent gain will be a part of financial history, just like similar gains enjoyed many years ago by RIMM, CSCO, and YHOO.
Although Apple has slid since then, surprisingly, shares of its smart phone maker competitor Research In Motion (RIMM) have nearly doubled.



Hedging AAPL With Optimal Puts in August

Back in August, I tweeted from the Portfolio Armor Twitter account the optimal put* to hedge Apple against a greater-than-20% drop over the next six months:
:

As $AAPL hits a new high, the cost of hedging it against a >20% drop between now and February. twitter.com/PortfolioArmor…

— Portfolio Armor (@PortfolioArmor) Aug. 17, 2012
That put is getting a little long in the tooth now, but since AAPL has dropped 22.9% since then, it has done its job: if an AAPL long who purchased that put on Aug. 17 were to exercise it now, his loss would be limited to 20%, taking into account the initial cost of the put. Since the put still has some time value left (see the screen cap of the Yahoo quote page for it below), he'd have a smaller loss if he sold the put and his AAPL shares now -- in that case, his loss would be limited to 17.7%.





Hedging AAPL and RIMM with Optimal Puts Now


If an AAPL long wanted to hedge against another 20%+ drop in his shares from here, he'd be able to find optimal puts to do that now -- and for a fairly low cost, considering Apple's recent slide. But despite RIMM's recent rise, it is currently too expensive to hedge against a greater-than-20% drop from here:



Since the cost of hedging RIMM against a greater-than-20% drop was itself greater than 20% on Friday, Portfolio Armor indicated there were no optimal puts available for it (there was an optimal put available to hedge RIMM against a >21% drop, but the cost of it, as a percentage of position value, was 20.15%). This is a case where -- for longs willing to cap their potential upside -- being able to scan for an optimal collar** would come in handy.

That capability is now live on the website, and coming soon to the iOS app (where it will be available as an in-app subscription). It has been generating some interesting results, including a number of instances where the optimal collars are zero cost, or even have negative net costs (i.e., the income from the calls you sell as part of the collar is greater than the cost of the puts you buy, so you are getting paid to hedge). Below we'll take a look at the optimal collars to hedge $50,000 positions in AAPL and RIMM against greater-than-20% declines from here, for investors willing to cap their potential upsides from here at 15%.

Hedging AAPL and RIMM With Optimal Collars Now

As you can see in the screen captures below, for longs willing to cap their potential upsides at 15% while limiting their potential downside risk to drops of no more than 20%, the optimal collars are negative cost collars in both cases: the investors would get paid to hedge.



*Optimal puts are the ones that will give you the level of protection you want at the lowest possible cost. Portfolio Armor (available on the web and as an Apple iOS app), 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 extension to the Portfolio Armor algorithm to find optimal collars was developed by a post-doctoral fellow in the financial engineering department at Princeton University.

About the author:

DaveinHackensack

Visit DaveinHackensack's Website


Rating: 2.8/5 (9 votes)

Comments

rwd77
Rwd77 premium member - 1 year ago
A post from a long term investor!
jonmonsea
Jonmonsea premium member - 1 year ago
How do you look at the decision to hedge vs. the decision to hold cash and maybe not commit fully to the position. It seems like the 20% threshold isn't a hedge against total capital loss but having gotten in too soon, as it were. If you had cash, you could buy more, thus increasing your return. If the stocks soared you'd be saved the hedging cost---in this scenario, the AAPL would be called away from you at 581$, right? Thanks. I' dealing with this myself and would love to learn more from your perspective
DaveinHackensack
DaveinHackensack - 1 year ago
Jonmonsea,

Good questions. A couple of comments in response:

1) You can use a different threshold if you like, but all things equal, the smaller the threshold, the more expensive it will be to hedge, and vice-versa.

2) You suggest that if you had cash you could buy more if the stock went down, but this is also true if you are hedged: if you are still bullish on the stock after a significant decline, you can sell your (appreciated) hedge and use that cash to buy more stock.

3) Regarding the cost of hedging, let's differentiate between the two different hedges we showed for Apple, the first, the optimal put had a cost -- 2.76% of your position value -- but the second, the optimal collar, had a negative net cost, i.e., you didn't pay to hedge; you got paid to hedge. And yes, that second hedge means your Apple stock could be called away from you if it appreciates above $580 over the next several months. Since that has a cap of 15%, it would make sense to hedge that way if you didn't expect Apple to appreciate more than 15% during that time frame.

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