In an article last week ("Best e-Commerce Stocks For 2012 By Goldman Sachs"), Insider Monkey listed seven stocks that analysts at Goldman Sachs predicted would benefit from growth in the Internet sector in 2012. One way to limit risk while investing in these sorts of stocks is to hedge them. The table below shows the costs of hedging these stocks against greater-than-37% declines over the next several months, using optimal puts.
For comparison purposes, I've also added the cost of hedging the Nasdaq 100-tracking ETF PowerShares QQQ Trust ETF (NASDAQ:QQQ). Something worth noting in the table below is that the index-tracking ETF QQQ is considerably less expensive to hedge than any of these individual E-Commerce stocks. Bearing this in mind, an investor who feels he owns enough different stocks to be diversified against stock-specific risk may want to consider buying optimal puts on an index-tracking ETF such as QQQ to hedge against market risk, in lieu of hedging each of his individual stocks. First, a reminder about what optimal puts are, plus a note about why I've used 37% as a decline threshold here. Then, a screen capture showing the optimal puts for the comparison ETF, QQQ.
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.
In this context, "threshold" is the maximum decline you are willing to risk. 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). Usually, I use 20% decline threshold when hedging equities, but one of these stocks, Groupon, Inc. (NASDAQ:GRPN), was too expensive to hedge using a 20% threshold (i.e., the cost of hedging them against a 20% decline was itself more than 20% of position value, so Portfolio Armor indicated there were no optimal contracts available for them). The smallest decline threshold against which it was possible to hedge Groupon with optimal puts was 37%, so that's the threshold I've used for all the names in the table below.
The Optimal Puts to Hedge QQQ
Below is a screen capture showing the optimal put option contract to buy to hedge 100 shares of QQQ against a greater-than-37% drop between now and June 15, 2012. A note about these optimal put options and their cost: To be conservative, we 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 (this is true of the costs in the table below as well).
Hedging Costs As Of Friday's Close
Hedging costs are presented as percentages of position value. Regarding the stock below with the highest hedging cost, Groupon, recall a previous article ("High Optimal Hedging Costs: A Red Flag?") where we speculated that high hedging costs could presage future underperformace.
|Amazon.com, Inc.|| |
|QQQ||PowerShares QQQ Trust||0.61%**|
*Based on optimal puts expiring in May, 2012
**Based on optimal puts expiring in June, 2012
***Based on optimal puts expiring in July, 2012