Preparing For A Drop In Google's (Alphabet's!) Stock

| About: Alphabet Inc. (GOOG)

Summary

Google parent Alphabet traded the top spot in market capitalization with Apple this week after posting seemingly strong earnings. Seeking Alpha contributor Bill Maurer raised a warning though.

Maurer noted that Alphabet's earnings would have looked less impressive if not for the company's low effective tax rate, and wondered if the stock's valuation might compress going forward.

We present a couple of ways for Alphabet shareholders to lock in some of their gains in the event the stock slides over the next several months.

Alphabet And Apple Jockey For Position

Last week, the pop-culture site A.V. Club posted about the 1968 classic film Bullitt ("Action cinema begins with Steve McQueen and one incredible car chase"). The chase starts in San Francisco, and in the still below (image via the A.V. Club post), McQueen, in his Mustang, jockeys for position with the bad guys in their Charger in the peninsula south of the city.

Click to enlarge

We were reminded of that image this week as Google parent Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL) and Apple (NASDAQ:AAPL) traded the title of the world's largest company by market cap. After releasing seemingly strong earnings driven by the performance in its core businesses late Monday, Alphabet overtook Apple's market cap on Tuesday, only for AAPL to swing back ahead as Google/Alphabet dropped about 5% on Wednesday. Despite Wednesday's drop, Alphabet's shareholders were up about 38% over the trailing 12 months, as of Wednesday's close, versus a decline of about 7.3% for the S&P 500 index over the same time frame.

Bill Maurer Waives A Warning Flag

Seeking Alpha contributor Bill Maurer waved a warning flag about Alphabet's earnings on Tuesday (Alphabet: The Elephant In The Room), noting that the company's Q4 earnings benefited from an unusually low effective tax rate of 5%:

In the end, Alphabet's quarter was not as impressive as the headline results suggest. A big tax break fueled the bottom line beat, likely hiding a drop in quarterly GAAP net income. Over the next couple of years, Alphabet will need to keep spending in check to avoid a big drop in net profit margins. With the stock at an all-time high currently and trading at a valuation higher than Apple, it will be interesting to see how investors react as growth slows, capital returns likely increase, and the valuation potentially comes down.

In the comments on Maurer's article, Seeking Alpha contributor Andreas Hopf pithily summarized the cautious case:

Tax breaks. Dependence on advertising. How much longer can it last?

For Google/Alphabet longs who want to keep holding the stock but lock in some of their past gains in the event shares slide over the next several months, we'll look at a couple of ways of hedging the stock below. First, we'll recap 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 Alphabet With An Optimal Put

We're going to use Portfolio Armor's iOS app to find an optimal put and an optimal collar to hedge Alphabet below, but you don't need the app to do this. You can find optimal puts and 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, an additional piece of information you'll need to supply (in addition to the number of shares you're looking to hedge) when scanning for an optimal put is your "threshold", which refers to the maximum decline you are willing to risk. This will vary depending on your risk tolerance. For the purposes of the examples below, we've used a threshold of 15%. If you are more risk averse, you could use a smaller threshold (for an example of positions, including a couple of exotic ones, hedged with a 10% threshold, see "Ladies Love Low Risk"). And if 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.

Here is the optimal put, as of Wednesday's close, to hedge 100 shares of Alphabet against a greater-than-15% drop by mid-September.

As you can see at the bottom of the screen capture above, the cost of this protection was $3,530, or 4.86% of position value. A couple of points about this cost:

  1. To be conservative, the cost was based on the ask price of the put; in practice, you can often buy puts for less (at some price between the bid and ask).
  2. The 15% threshold includes this cost, i.e., in the worst case scenario, your Alphabet position would be down 10.14%, not including the hedging cost.

Hedging Alphabet With An Optimal Collar

When scanning for an optimal collar, you'll need one more figure in addition to your threshold, your "cap", which 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 seven-month period, and you think a security won't appreciate more than 10% over that time frame, then it might make sense to use 10% as a cap: you don't think the security is going to do better than that anyway, 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 used a cap of 12.4%, because that was the Portfolio Armor website's estimate of Alphabet's potential return over the time frame of the hedge. Every trading day, the site ranks every hedgeable stock and exchange-traded product (such as ETFs) by its potential return. Potential return, in its terminology, is a bullish estimate of how a security will perform over the next several months. As of Wednesday's close, the site calculated a potential return of 12.4% for Alphabet. By way of comparison, Facebook (NASDAQ:FB) had a potential return of 11.5%. The site only calculates potential returns for securities when the mean of the most recent six-month return and the average six-month return over the long term is positive; that wasn't the case for AAPL on Wednesday.

As of Wednesday's close, this was the optimal collar to hedge 100 shares of Alphabet against a greater-than-15% drop by mid-September while not capping an investor's upside by less than 12.4%.

As you can see in the first part of the optimal collar above, the cost of the put leg was $2,430, or 3.34%, 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 $2,770, or 3.81% of position value.

So the net cost of this optimal collar was negative, meaning an investor would have collected $340 more from selling the call leg than he paid for the puts, an amount equal to 0.47% of his position value. Two notes on this collar hedge:

  1. Similar to the situation with the optimal put, to be conservative, the cost of the optimal collar 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 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 $340 when opening this collar.
  2. Although the threshold on this collar is 10%, 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 negative hedging cost, would be a decline of less than 10%: assuming, conservatively, a negative cost of 0.47%, the maximum drawdown here would be 9.53%. Similarly, the best-case scenario wouldn't be 12.4%, the level at which this collar is capped, but 12.4% + 0.47% = 12.87%.

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.