Intercept Spikes On Another Buyout Rumor
If you own shares of Intercept Pharmaceuticals (NASDAQ:ICPT), you know the stock spiked 27.5% on Friday, apparently on another buyout rumor, as reported by Seeking Alpha news editor Douglas W. House. House noted that last time around, the rumor was Intercept would be bought by Shire plc (NASDAQ:SHPG). In this article, we'll look at adding downside protection to Intercept (something you probably wish you had done two years ago, if you owned the stock then).
Adding Downside Protection To Intercept
We're going to show two different ways of hedging Intercept, first using optimal puts, and then using an optimal collar. For a fuller explanation of hedging terms, you can see the paragraph titled "Refresher On Hedging Terms" in our previous article, Locking In Gold Gains, but, in a nutshell, optimal puts offer uncapped upside, while with optimal collars, you give up some of your potential upside in order to offset the cost of hedging. We're going to use Portfolio Armor's iOS app to find the hedges 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, a piece of information you'll need to supply (along with 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, but there may not be an optimal hedge at the threshold you want.
For example, if you wanted to hedge ICPT over the next several months using optimal puts, as of Friday's close, the smallest threshold you could use was 28%. Below are the optimal puts, as of Friday, February 12th's close, to hedge 400 shares of ICPT against a >28% drop by mid-September. Note that we don't expect any investor would want to spend this much to hedge; we're presenting these optimal puts to illustrate how expensive the stock was to hedge this way.
As you can see at the bottom of the image above, the cost of this put protection was $13,200, or 27.45% of position value. 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). And the 28% threshold includes this cost, i.e., in the worst-case scenario, your ICPT position would be down 0.55%, not including the hedging cost. But the hedging cost does count, and it's enormous. So let's look at hedging it with an optimal collar.
Hedging ICPT 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 16% and a threshold of 16%. As of Friday's close, this was the optimal collar to hedge 400 shares of ICPT against a greater than 16% drop by mid-September while not capping an investor's upside by less than 16%.
As you can see in the first part of the optimal collar above, the cost of the put leg was $7,600, or 15.80%, 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 $8,440, or 17.55% of position value.
So the net cost of this optimal collar was negative, meaning an investor would have collected $854 more from selling the call leg than he paid for the puts, an amount equal to 1.75% of his position value. Two notes on this collar hedge:
- 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 $854 when opening this collar.
- The best-case scenario wouldn't be 16%, the level at which this collar is capped, but 16% + 1.75% = 17.75%.
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.