Hedging Groupon Before And After Its Recent Decline

Dec. 1.11 | About: Groupon, Inc. (GRPN)

Groupon shares spike on Wednesday, as risk assets rally

Shares of Groupon, Inc. (GRPN) rose 9.24% on Wednesday, November 30th, to close at $17.49, as risk assets rallied in response to the coordinated central bank action to boost liquidity on Wednesday morning. In this post we'll look at the current optimal puts, post-rally, to hedge Groupon against a greater-than-35% drop over the next several months, and also the current costs of hedging a few other tech companies for comparison. Before that, we'll take a look at how a previous hedge on Groupon against a greater-than-35% decline reacted as the underlying stock fell almost exactly that much -- 35.4% -- from November 17th to November 29th. First, a reminder about optimal puts and decline thresholds.

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" is the maximum decline you are willing to risk. Another way of thinking about it is this: the percentage you can tolerate losing. In this case, since we're using 35% as a decline threshold, we are indicating that we could tolerate a 35% loss, but not a loss greater than that. 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). We used 35% as a decline threshold when calculating a hedge for it on November 17th because Groupon was too expensive to hedge against a significantly smaller threshold then.

Hedging Groupon on November 17th

In a Seeking Alpha article published the following day ("No Daily Deal: Groupon is Expensive to Hedge"), we included this screen capture, showing the optimal put option contract to buy to hedge 100 shares of GRPN against a greater-than-35% drop between then and April 20, 2012. A note about these optimal put options and their cost: to be conservative, Portfolio Armor 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.

Click to enlarge

Groupon closed at $24.77 on November 17th. If an investor purchased 100 shares of it at that closing price, and purchased the optimal puts above at their ask price, his total investment (underlying stock + option hedge) would have looked like this at the time:

Option Hedge: 1 contract (100 puts) GRPN120421P00022000 = $550

Underlying Stock: 100 shares of GRPN @ $24.77 = $2,477

Total = $3,027

Groupon and that hedge on November 29th:

On November 29th, Groupon closed at $16.01, down 35.4% from its closing price on November 17th. The screen capture below shows the quote for the $22 strike, April expiry put options on it on the 29th. Note that the ask price has jumped from $5.50 in the screen capture above to $9.60 in the screen capture below, and the last trade on the 29th was at $9.50. However, to be conservative, we'll work with the bid price of $9.00 below.

Here's what our hypothetical investor's underlying stock + option hedge would have looked like on November 29th:

Option Hedge: 1 contract (100 puts) GRPN120421P00022000 up 63.6% at the bid of $9.00 = $900

Underlying Stock: 100 shares of GRPN down 35.4% @ $16.01 per share = $1601

Total = $2,501

Net decline of hedged position as stock drops 35.4%

Remember that, on November 17th, by buying the optimal puts to hedge against a greater-than-35% decline, our hypothetical investor was indicating that he was willing to tolerate a 35% decline-- but not a larger one. Let's say he decided to sell both his shares and his hedge on November 29th, after the stock had declined 35.4% from November 17th. What loss would he have incurred? The difference in value between his combined positions on November 17th and November 29th was ($3,027 - $2,501) = $526, which represents a 17.4% decline. So, in this case, the hedge he bought to protect himself against a greater-than-35% decline would have actually protected him against a greater than 17% decline.

The optimal puts to hedge Groupon now

Below is a screen capture showing the optimal put option contract to hedge 100 shares of GRPN against a greater-than-35% decline as of Wednesday's close. Note that this is a different options contract, with a lower strike price than the one in the screen capture above, as this is a hedge against a 35% drop from a lower share price.

Hedging costs as of Wednesday's close

The table below shows the costs of hedging several other leading tech stocks against greater-than-35% declines over the next several months, as of Thursday's close.

Symbol

Name

Cost of Protection (as % of position value)

GRPN Groupon, Inc. 19.4%*
LNKD LinkedIn 14.1%**
AMZN

Amazon.com

2.03%*

NFLX

Netflix

11.9%***

CRM Salesforce.com 4.69%**
AKAM Akamai Technologies 3.63%**
JNPR Juniper Networks 3.17%*
OPEN OpenTable, Inc. 5.51%*
AAPL Apple, Inc. 0.85%*
GOOG Google, Inc. 1.25%***
QQQ PowerShares QQQ Trust 1.33%***
Click to enlarge

*Based on optimal puts expiring in April, 2012

**Based on optimal puts expiring in May, 2012

***Based on optimal puts expiring in June, 2012

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