## Executive summary:

- You can hold a position in InterMune while strictly limiting your downside risk with a hedged portfolio, such as the one shown below.
- This portfolio has a negative hedging cost, meaning you would effectively be getting paid to hedge.
- This portfolio is designed for an investor who wants to maximize his potential return while limiting his downside risk to a drawdown of no more than 16%.
- Investors with higher or lower risk tolerances can use a similar process, though their potential returns may be different.

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Shares of biotech company InterMune, Inc. (NASDAQ:ITMN) declined 14.87% Wednesday after having rocketed up 170% the previous day, on news of positive Phase III test results for its lung disease drug pirfenidone (brand name Esbriet). The company announced that it would resubmit the drug, designed to treat a form of pulmonary fibrosis, for FDA approval in the third quarter; the FDA had rejected it in 2010, but since then, InterMune has successfully gotten the drug approved by regulators in Europe as well as in Canada, Japan, and South Korea, among other places. Seeking Alpha contributor Bioassociate Consulting provided a detailed drill-down on InterMune, its drug, and the disease it treats, idiopathic pulmonary fibrosis, in an article published earlier this month ("InterMune Is Set To Outperform Its Main Competitor").

Given its huge run-up earlier this week, and the risks inherent in single-product biotech stocks (for example, the possibility of another rejection by the FDA) some InterMune investors may want to add downside protection here. One way to do that would be to construct a hedged portfolio around an InterMune position.

Let's review some of the basics of hedged portfolios, and then see how we can go about creating one around a InterMune position for an investor with $150,000 to invest, who wants to maximize his potential return with the constraint that he wants to limit his downside risk to a drawdown of no more than 16% in a worst-case scenario.

## Risk Tolerance, Hedging Cost, and Potential Return

All else equal, with a hedged portfolio, the greater an investor's risk tolerance -- the greater the maximum drawdown he is willing to risk (his "threshold") -- the lower his hedging cost will be and the higher his potential return will be.

## Constructing A Hedged Portfolio

In a previous article ("Rethinking Risk Management: A New Approach To Portfolio Construction"), we discussed a process investors could use to construct a hedged portfolio designed to maximize potential return while limiting risk. We'll recap that process here briefly, and then explain how you can implement it yourself. Finally, we'll present an example of a hedged portfolio that was constructed this way with an automated tool. The process, in broad strokes, is this:

- Find securities with high expected returns.
- Find securities that are relatively inexpensive to hedge.
- Buy a handful of securities that score well on the first two criteria; in other words, buy a handful of securities with high expected returns net of their hedging costs (or, ones with high net expected returns).
- Hedge them.

The potential benefits of this approach are twofold:

- If you are successful at the first step (finding securities with high expected returns), and you hold a concentrated portfolio of them, your portfolio should generate decent returns over time.
- If you are hedged, and your return estimates are completely wrong, on occasion -- or the market moves against you -- your downside will be strictly limited.

## How to Implement This Approach

**Finding securities with high expected returns.**Presumably, if you held onto your ITMN shares after Tuesday's run-up, you expect it to have a decent return from here. To find other securities with high expected returns to complement it, you could, for example, look at the top holdings of a billionaire investor, as we did with Carl Icahn's holding company in a recent article ("Investing Alongside Carl Icahn While Limiting Your Downside Risk"). Or, if you want to have a more Biotech focused portfolio, you could look at the top holdings of a highly-rated biotech fund. To quantify expected returns for these securities, you can, for example, use analysts' price targets for them and then convert those to percentage returns from current prices. In general, though, you'll need to use the same time frame for each of your expected return calculations to facilitate comparisons of expected returns, hedging costs, and net expected returns. Our method starts with calculations of six-month expected returns.**Finding inexpensive ways to hedge these securities**. First, you'll need to determine whether each of these are hedgeable. Then, whatever hedging method you use, for this example, you'd want to make sure that each security is hedged against a greater-than-16% decline over the time frame covered by your expected return calculations (our method attempts to find optimal static hedges using collars as well as married puts going out approximately six months). And you'll need to calculate your cost of hedging as a percentage of position value.**Buying the securities with the highest net expected returns.**In order to determine which securities these are, you'll need to subtract the hedging costs you calculated in the previous step from the expected returns you calculated for each position, and sort the securities by their expected returns net of hedging costs, or net expected returns. If any of the names in your sort have negative net expected returns (that is, the cost of hedging them is more than their expected return over the same time frame), you'll want to exclude them.**Fine-tuning portfolio construction**. You'll want to stick with round lots (numbers of shares divisible by 100) to minimize hedging costs, so if you're going to include a handful of securities from the sort in the previous step and you have a relatively small portfolio, you'll need to take into account the share prices of the securities. For example, for an investor with, say, a $100,000 portfolio, stocks such as Priceline.com (NASDAQ:PCLN), trading at more than $1000 per share, would be problematic. Another fine-tuning step is to minimize cash that's leftover after you make your initial allocation to round lots of securities and their respective hedges. Because each security is hedged, you won't need a large cash position to reduce risk. And since returns on cash are so low now, by minimizing cash you can potentially boost returns. In this step, our method searches for what we call a "cash substitute": that's a security collared with a tight cap (1% or the current yield on a leading money market fund, whichever is higher) in an attempt to capture a better-than-cash return while keeping the investor's downside limited according to his specifications. You could use a similar approach, or you could simply allocate leftover cash to one of the securities you selected in the previous step.

## An Automated Approach

Here we'll show an example of creating a hedged portfolio around a InterMune position using the general process described above, facilitated by the automated portfolio construction tool at Portfolio Armor. In the first step, we'll enter the ticker symbol ITMN, the dollar amount of our investor's portfolio (150000), and the maximum decline he's willing to risk in percentage terms (16). We'll leave the strategy set to the default, "Maximize Potential Return".

In the second step, we're given the option of entering our own expected returns for Intermune. In this example, we will leave this blank, and use the tool's own expected return calculation.

A few minutes after clicking the "create" button above, we were presented with this hedged portfolio. The data in it are as of Wednesday's close.

## Why These Additional Securities?

In addition to InterMune, the tool added Advanced Auto Parts (NYSE:AAP), Apollo Education (NASDAQ:APOL), Micron Technology (NASDAQ:MU), and Wynn Resorts (NASDAQ:WYNN) to the portfolio in its primary allocation, based on their high net expected returns. As part of its fine-tuning step, the tool added Youku Tudou, Inc. (NYSE:YOKU) as a cash substitute, hedged with an optimal collar with its cap set at 1%. Although it's capped at 1%, the net expected return of the YOKU position is actually 10.18%, because its hedging cost is -9.18%.

## Each Security Is Hedged

Note that in the portfolio above, each of the underlying securities is hedged. Hedging each security according to the investor's risk tolerance obviates the need for broad diversification, and lets him concentrate his assets in a handful of securities with high expected returns net of their hedging costs. Here is a closer look at the hedge for InterMune.

As you can see in the image at the link above, ITMN is hedged with an optimal collar with its cap set at 14%. Using an analysis of historical returns as well as option market sentiment, the tool calculated an estimated return of 14% for ITMN over the next several months. That's why 14% is used as the cap here: the idea is to capture the expected return while offsetting the cost of hedging by selling other investors the right to buy InterMune if it appreciates beyond 14% over the next several months. Now, if you currently own ITMN, and believe that the stock will appreciate by much more than 14% over the next several months, remember, you can enter your own expected return for the stock in Step 2 above. As you can see at the bottom of the screen capture, the net cost of this optimal collar, as a percentage of position value, was 0.78%.[ii]

## Negative Hedging Cost

Although minimizing hedging cost was only the secondary goal here after maximizing potential return, note that, in this case, the total hedging cost for the portfolio was negative, meaning the investor would have effectively gotten paid (about $736) to hedge this portfolio.

## Higher Risk, Higher Potential Return

As we noted in a previous article, a hedged portfolio for an investor willing to risk no more than a 5% decline featured a potential return of 3.71%. This hedged portfolio, for an investor willing to risk a 16% decline, features a potential return of 19.46% over six months.

That potential return is what the portfolio will return if each of its underlying securities achieves its expected return. Since it's more likely that some of the securities will fall short of their expected returns and some will exceed their expected returns, and since the collared securities have their upsides capped, the actual return of this portfolio may trail its potential return. But in the worst-case scenario -- if InterMune and every other one of these securities went to zero before their hedges expired -- the investor's downside would be strictly limited to a decline of 15.61%.

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[i] To be conservative, the net cost of the collar was calculated using the bid price of the calls and the ask price of the puts. In practice, an investor can often sell the calls for a higher price (some price between the bid and ask) and he can often buy the puts for less than the ask price (again, at some price between the bid and ask). So, in practice, an investor may have been able to get this hedge for less than $175, or 0.78% of the position value. Bear in mind that if we had entered a higher expected return for the ITMN in Step 2, all else equal, the cost of hedging it would have been higher as well.

**Disclosure: **I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.