Hedging Facebook Ahead Of Earnings

| About: Facebook (FB)


It's a sign of how dominant Facebook has become that skeptics are so scarce, but despite Estimize's bullish earnings estimate, there are reasons for caution in the near-term.

We discuss those reasons for caution, including SA contributor Alex Pitti's thesis of Facebook's recession risk, and J.C. Parets' bearishness on the market as a whole.

For Facebook shareholders concerned about near-term risk but unwilling to sell, we present an optimal collar hedge.

Facebook Skeptics Are Scarce These Days

Prior to its IPO in 2012, Facebook (NASDAQ:FB) had its share of skeptics. One of the most prominent ones was David Heinemeier Hansson, creator of the Ruby on Rails web application framework, and partner in the software firm Basecamp (formerly known as 37 Signals). In a late 2010 post, Hansson wrote that "Facebook is not worth" $33 billion, referring to its valuation at the time as a private company. Hansson assumed that private valuation wouldn't withstand the scrutiny of the stock market.

As former Facebook employee and current angel investor Bobby Goodlatte reminded us via Twitter last fall (see image below), Facebook, as a public company, ended up worth almost 10x more than its valuation when Hannson wrote the post we linked to above.

Facebook's shares have pulled back a bit since Goodlatte's tweet - as of January 25th's close, FB's market cap was about $274 billion - but Facebook skeptics remain hard to find. Still, there are reasons for caution in the near-term. We'll look at a couple of reasons for that below, consider two other perspectives on the company, and offer an optimal collar hedge for Facebook shareholders looking to limit their downside risk.

Reasons For Caution

In an article earlier this month (Why I Sold My Facebook), Seeking Alpha contributor Alex Pitti, who remains a long-term bull on the company, offered an interesting fundamental reason for caution in the near-term. Drawing on his earlier prediction of a 2016 recession, Pitti argued that Facebook is a cyclical business that will be affected by a slowdown in ad spending during the recession. He noted that this wasn't the case during the last recession, but that was only because Facebook's share of advertising dollars was so small at the time that it still had plenty of room to grow. Now that it's an established behemoth, Pitti argues that Facebook will be more sensitive to a decline in ad spending across the board.

Another reason for caution relates to the stock market as a whole. In an interview with Bloomberg TV on Monday, Eagle Bay Capital president J.C. Parets argued that the performance of the financial sector, as represented by the Financial SPDR ETF (NYSEARCA:XLF), and illustrated in the chart below (image via Bloomberg TV), boded poorly for the broader market. If we were still in a bull market, Parets argued, he would expect financials to be leading the way higher.

Facebook Earnings Estimates: Estimize > Wall Street

Facebook is scheduled to release its earnings after the close on Wednesday. As the chart below from Estimize shows, the Estimize community expects Facebook to report earnings of 69 cents per share in its FQ4 2015, one penny above the Wall Street consensus estimate.

Portfolio Armor Potential Return

Every trading day, Portfolio Armor ranks every hedgeable stock and exchange-traded product (such as ETFs) by its potential return. Potential return, in our terminology, is a bullish estimate of how a security will perform over the next 6 months. As of Monday's close, the site calculated a potential return of 2.6% for Facebook. By way of comparison, this was the worst potential return the site calculated for "FANG" stocks on Monday: Netflix (NASDAQ:NFLX), the subject of our recent article, "Netflix And Chill", had a potential return of 5.3%, Alphabet Class A shares (NASDAQ:GOOGL) were second highest, with a potential return of 7.7%; and Amazon (NASDAQ:AMZN) had the highest potential return of any security in our universe at 30%. With our potential return for Facebook in mind, we'll look at a way of hedging it below. First, a quick reminder about a few hedging terms.

Refresher On Hedging Terms

Recall that puts (short for put options) are contracts that give an investor the right to sell a security for a specified price (the strike price) before a specified date (the expiration date). And calls (short for call options) are contracts that give an investor the right to buy security for a specified price before a specified date.

A collar is a type of hedge in which you buy a put option for protection, and, at the same time, sell a call option, which gives another investor the right to buy the security from you at a higher strike price, by the same expiration date. The proceeds from selling the call option can offset at least part of the cost of buying the put option. An optimal collar is a collar that will give you the level of protection you want at the lowest cost, while not capping your possible upside by more than you specify. In a nutshell, with a collar you may be able to reduce the cost of hedging, in return for giving up some possible upside.

Hedging Facebook With An Optimal Collar

We're going to use Portfolio Armor's iOS app to find an optimal collar to hedge Facebook below, but you don't need the app to do this; you can find optimal collars yourself by using the process we outlined in this article, if you're willing to take the time and do the work. Whether you run the calculations yourself using the process we outlined, or use the app, two pieces of information you'll need to supply (in addition to the number of shares you're looking to hedge) are your "cap" and your "threshold". "Cap" refers to the maximum upside you are willing to limit yourself to if the underlying security appreciates significantly.

A logical starting point for the cap is your estimate of how the security will perform over the time period of the hedge. For example, if you're hedging over a 5-month period, and you think a security won't appreciate more than 8% over that time frame, then it might make sense to use 8% as a cap: you don't think the security is going to do better than that, so you're willing to sell someone else the right to call it away if it does better than that. For the example below, we started off using a cap of 2.6%, the potential return our site calculated for Netflix, but we raised it to 3%, because that was as high as we could raise it without raising the hedging cost. All else equal though, the lower the cap, the less expensive it will be to hedge.

The other term, "threshold", refers to the maximum decline you are willing to risk. This will vary depending on your risk tolerance. For the purposes of the example below, we've used a threshold of 8%. If you are more risk averse, you could use a smaller threshold, and you are less risk averse, you could use a larger one. All else equal though, the higher the threshold, the cheaper it will be to hedge.

As of Monday's close, this was the optimal collar to hedge 200 shares of FB against a >8% drop over the next several months, while not capping an investor's upside by less than 3%:

As you can see in the first part of the optimal collar above, the cost of the put leg was $970, or 5% as a percentage of position value. But if you look at the second part of the collar below, you'll see the income generated by selling the call leg was $1,460, or 7.52% of position value.

So the net cost of this optimal collar was negative, meaning an investor would have collected $490 more from selling the call leg than he paid for the puts, an amount equal to 2.53% of his position value.

Two Final Notes On This Hedge

  1. Note that, to be conservative, the cost of the hedge above was calculated using the ask price of the puts and the bid price of the calls; in practice, an investor can often buy puts for less (at some price between the bid and the ask), and sell calls for more (again, at some price between the bid and the ask), so, in reality, an investor would likely have collected more than $490 when opening this collar.
  2. Although the threshold on this collar is 8%, and thresholds are calculated to take into account positive hedging costs, they don't take into account negative hedging costs. So, the worst case scenario in this case, when taking into account the hedging cost, would be a decline of less than 8%: assuming, conservatively, a negative cost of 2.53%, the maximum drawdown here would be 5.47%. Similarly, the best case scenario wouldn't be 3%, the level at which this collar is capped, but 3% + 2.53% = 5.53%.

Disclosure: I/we 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.