An Updated Look at Internet 2.0 Hedging

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Includes: AAPL, AKAM, AMZN, CRM, GOOG, HHH, JNPR, LNKD, MSFT, NFLX, OPEN, P
by: David Pinsen

In previous Seeking Alpha articles, 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: buying puts on an internet ETF, and buying puts on leading internet stocks.

Buying Puts on an Internet ETF

In the first table below is the current cost of hedging against a greater-than-25% decline in the Merrill Lynch Internet HOLDRs ETF (NYSE:HHH), using the optimal puts for that, but first a quick reminder about what “optimal” means in this context. and a note about decline thresholds.

Optimal Puts

Optimal puts are the ones that will give you the level of protection you want at the lowest possible cost. As University of Maine finance professor Dr. Robert Strong, CFA has noted, picking the most economical puts can be a complicated task. With Portfolio Armor (available in Seeking Alpha's Investing Tools Store and as an Apple iOS app), you just enter the symbol of the stock or ETF you're looking to hedge, the number of shares you own and the maximum decline you're willing to risk (your threshold). Then the app uses an algorithm developed by a finance academic to sort through and analyze all of the available puts for your position, scanning for the optimal ones (there's an example of this, with screen-shots, in this recent Seeking Alpha article).

Decline Thresholds

I generally use 20% thresholds when hedging, for reasons I mentioned in a previous article on hedging, but since I used 25% thresholds in the initial article on hedging internet names, I have used 25% thresholds here as well.

How Costs Are Calculated

To be conservative, Portfolio Armor calculated the costs below based on the ask prices of the optimal put options. In practice, though, an investor may be able to buy some of these put options for less (i.e., at a price between the bid and the ask).

Hedging Costs of an Internet ETF

Below are the costs, as of Monday's close, of hedging the Merrill Lynch Internet HOLDRs ETF (HHH) against a greater-than-25% decline 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 (NASDAQ:QQQ) and the S&P 500-tracking ETF SPDR S&P 500 Trust (NYSEARCA:SPY) against similar declines.

Symbol

Name

Cost of Protection (as % of position value)

HHH

Merrill Lynch Internet HOLDRs

2.71%**

QQQ PowerShares QQQ Trust 0.98%*
SPY SPDR S&P 500 Trust
0.89%*
Click to enlarge
Click to enlarge

*Based on optimal puts expiring in January, 2012

**Based on optimal puts expiring in February, 2012

Buying Puts on a Basket of Internet Stocks

Today, LinkedIn (NYSE:LNKD) is one of the first stocks that comes to mind when thinking of internet stocks, and since it now has options traded on it, I've added it to the table below, along with Pandora Media, Inc. (P), which recently went public. The first candidate I had thought of for a basket of leading internet stocks in March was Open Table (NASDAQ: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 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 (NASDAQ:AMZN), Netflix (NASDAQ:NFLX), Salesforce.com (NYSE:CRM) and internet infrastructure plays Akamai Technologies (NASDAQ:AKAM) and Juniper Networks (NYSE:JNPR). Since Mark Andreessen was quoted about the current valuations of Apple, Inc. (NASDAQ:AAPL), Microsoft Corporation (NASDAQ:MSFT) and Google, Inc. (NASDAQ:GOOG) above, I've added those names to the table below as well.

Hedging Costs of Leading Internet Stocks

Below are the costs, as of Tuesday's close, of hedging each of all but two of those stocks against greater-than-25% declines over the next several months.

Why There Were No Optimal Puts for LNKD or P

In some cases, the cost of protection may be greater than the loss you are looking to hedge against. That was the case with LinkedIn (LNKD) and Pandora Media, Inc. (NYSE:P). As of Tuesday, the cost of protecting against a greater-than-25% decline in each of those stocks over the next several months was itself greater than 25%. Because of that, Portfolio Armor indicated that no optimal contracts were found for them.

Symbol

Name

Cost of Protection (as % of position value)

LNKD LinkedIn No Optimal Puts at This Threshold
P Pandora Media, Inc. No Optimal Puts at This Threshold
AMZN

Amazon.com

2.96%*

NFLX

Netflix

5.11%*

CRM Salesforce.com 4.51%*
AKAM Akamai Technologies 3.85%*
JNPR Juniper Networks 3.59%*
OPEN OpenTable, Inc. 10.9%*
AAPL Apple, Inc. 1.66%*
GOOG Google, Inc. 1.18%*
MSFT Microsoft Corporation 1.27%*
Click to enlarge

*Based on optimal puts expiring in January, 2012

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