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In a Seeking Alpha article two months ago ("Hedging Against the Bursting of Internet Bubble 2.0") we looked at hedging in the context of the current Internet bubble:

Consider the case of a business owner whose revenues were closely tied to the fortunes of privately held, venture-backed start-ups in the sector: he couldn’t hedge against a collapse in those companies directly, but he could buy put protection against a big correction in some publicly traded securities in the Internet sector, as an indirect hedge.

We looked at two approaches then: buying puts on Internet ETFs, and buying puts on leading Internet stocks. I thought it might be worth revisiting this after the widely-anticipated IPO of LinkedIn (LNKD) last week.

Buying puts on Internet ETFs

Judging by their top 10 holdings, the First Trust Dow Jones Internet Index ETF (FDN), is more diversified than the Merrill Lynch Internet HOLDRs ETF (HHH), which has more than 40% of its assets in Amazon.com (AMZN) (I would expect LinkedIn (LNKD) to appear among the top ten holdings of these Internet ETFs when they publish their updated holdings). In the first table below are the put option contracts Portfolio Armor presented as the optimal ones to hedge against greater-than-25% declines in these ETFs, but first a quick reminder about what “optimal” means in this context. and a note about decline thresholds.

Optimal Put Option Contracts

The optimal put option contracts are the ones that will give you the level of protection you want at the lowest cost. Portfolio Armor uses a proprietary algorithm developed by a finance academic to find the optimal contracts to hedge stocks and ETFs.

Decline Thresholds

As I've noted in a recent article, with Portfolio Armor (available in Seeking Alpha's Investing Tools Store and as an Apple iOS app), you can enter any percentage you like for a threshold (the higher the percentage though, the greater the chance you will find optimal puts for your position). I generally use 20% thresholds when hedging, for reasons I mentioned in that article, but since I used 25% thresholds in the initial article on hedging Internet stocks and ETFs, I have used 25% thresholds here as well.

Hedging costs of Internet ETFs

Below are the costs, as of Friday's close, of hedging these ETFs against greater-than-25% declines over the next several months. Also included in this table, for comparison purposes, are the costs of hedging the Nasdaq 100-tracking ETF PowerShares QQQ Trust (QQQ) and the S&P 500-tracking ETF SPDR S&P 500 Trust (SPY) against similiar declines.

Symbol

Name

Cost of Protection (as % of position value)

FDN

First Trust Dow Jones Internet

8.45%*

HHH

Merrill Lynch Internet HOLDRs

2.08%**

QQQ PowerShares QQQ Trust 1.35%***
SPY SPDR S&P 500 Trust
1.05%***

*Based on optimal puts expiring in October, 2011

**Based on optimal puts expiring in November, 2011

***Based on optimal puts expiring in December, 2011

Buying puts on a basket of Internet stocks

Today, LinkedIn (LNKD) is one of the first stocks that comes to mind when thinking of Internet stocks, but it doesn't have options traded on it yet. The first candidate I thought of for a basket of leading Internet stocks in March was Open Table (OPEN), based partly on something Howard Lindzon wrote about the company on his blog last fall:

Nobody liked OpenTable.com when they went public in 2009. It has only tripled in 2010. OpenTable.com has the distribution with the restaurateurs and the brand name with the consumer. It took 10 plus years to get there. With $80 million in sales and $1.5 billion in market cap most smart people I know think it’s overvalued. That was 30 points ago. OpenTable.com will buy any talent and feature it needs. It is a much smarter way to own these fancy new start-ups and that is what the big money is doing. These momentum spurts can last much longer than you think. They are not that complicated. It helps to understand what’s happening in the start-up world at any given time and that’s why I love the intersection where I sit.

The “intersection” Lindzon referred to to there is between his roles as an investor in publicly traded companies, and as an entrepreneur and angel investor in start-ups. Other candidates for a basket of leading Internet stocks I thought of were Amazon.com (AMZN), Netflix (NFLX), Salesforce.com (CRM), and Internet infrastructure plays Akamai Technologies (AKAM) and Juniper Networks (JNPR).

Hedging costs of leading Internet stocks

Below are the costs of hedging each of those stocks against greater-than-25% declines over the next several months.

Symbol

Name

Cost of Protection (as % of position value)

AMZN

Amazon.com

1.96%*

NFLX

Netflix

2.08%***

CRM Salesforce.com 4.54%**
AKAM Akamai Technologies 3.77%**
JNPR Juniper Networks 1.93%*
OPEN OpenTable, Inc. 5.10%*

*Based on optimal puts expiring in October, 2011

**Based on optimal puts expiring in November, 2011

***Based on optimal puts expiring in December, 2011

Source: An Update on Hedging Against the Bursting of Internet Bubble 2.0