Hedging Tuesday's Apple Rally

| About: Apple Inc. (AAPL)

Summary

Shares of Apple rose along with the broader market rally, but given concerns that the rally may not be sustained, we look at two ways of hedging the stock.

Both hedging examples limit an investor's maximum drawdown to 15% over the next several months. One doesn't cap potential upside, and costs about 4.2% of position value.

The other example caps potential upside at 18% and costs about 1.8% of position value (we explain why we used 18% as a cap).

A Head Fake Or A Sustained Rally?

Shares of Apple (NASDAQ:AAPL) rose 2.8% on Tuesday, but that appears to have been more due to the broader recent global rally than any Apple-specific news (unless you believe Apple shareholders were cheered by the company filing to issue more bonds or the headlines that Carl Icahn and David Einhorn had reduced their stakes in Apple last quarter). So that raises the question of whether the recent market rally is a head fake before continued declines or the start of a sustained rally.

One market observer suggesting the recent rally may be a head fake is John Hussman, in his most recent market commentary "Warning with a Capital 'W'". The last time we referred to one of Hussman's forecasts in an article, readers were quick to remind us of how long he's been bearish. This time, we raised that issue with him first, via Twitter, as the screen capture from the site below shows.

Our comment about Hussman's generosity is an allusion to his charitable foundation, and our comment about his brilliance is an allusion to his impressive background, including a PhD from Stanford. One of the lessons and distinctions Hussman mentions in his most recent market commentary is that his old method of market forecasting didn't fully account for the effects of quantitative easing, so he revised his method in mid-2014. And that new method is now flashing a "warning with a capital 'W.'"

Acting On That Warning By Hedging

If you're concerned that the market might head south again, you might want to consider hedging your Apple shares. We'll look at a couple of ways of doing that below. First, though, a note about hedging and uncertainty, followed by a quick refresher on hedging terms.

Hedging As A Response To Uncertainty

If you know the future direction of the market or of a particular security with 100% certainty, then you don't need to hedge. Hedging is for those of us who aren't certain of what is going to happen. If you know with 100% certainty that the market is going to tank, you wouldn't want to own Apple at all. Instead, you would want to short the market or short whatever securities or sectors you think will do the worst.

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 a 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 Apple With Optimal Puts

We're going to use Portfolio Armor's iOS app to find an optimal put and an optimal collar to hedge AAPL 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 (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. For the purpose of the examples below, we've used a threshold of 15%. If you are more risk-averse, you could use a smaller threshold. 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 Tuesday's close to hedge 200 shares of AAPL against a greater-than-15% drop by mid-July.

As you can see at the bottom of the screen capture above, the cost of this protection was $820, or 4.24% of position value. Readers of our previous article on hedging Intercept Pharmaceuticals (NASDAQ:ICPT) will note the huge contrast in optimal put hedging cost between that drug stock and tech bellwether Apple. 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 AAPL position would be down 10.76%, not including the hedging cost.

Hedging AAPL 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.

We tried using Portfolio Armor's website to get an estimate of AAPL's potential return over the time frame of the hedge. Every trading day, the site runs 2 screens to avoid bad investments on every hedgeable security in the U.S., and then ranks the ones that pass by their potential return. Potential return, in its terminology, is a bullish estimate of how a security will perform over the next several months. Apple, however, didn't pass those 2 screens, so the site didn't calculate a potential return for it. So, instead, we calculated a potential return using Wall Street brokers' median price target for Apple as found on Yahoo Finance (the screen capture below is from Yahoo).

That median price target of $132 represents a 36.6% increase from Apple's Tuesday closing price of $96.64, but those price targets go out 1 year, and we're going to be hedging Apple out 5 months. So, we started out using 15.2% as a cap (5/12ths of 36.6%). But when we saw we were able to raise the cap to 18% without raising the hedging cost, we used that.

As of Tuesday's close, this was the optimal collar to hedge 200 shares of AAPL against a greater-than-15% drop by mid-July, while not capping an investor's upside by less than 18%.

As you can see in the first part of the optimal collar above, the cost of the put leg was $680, or 3.52%, 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 $328, or 1.70% of position value.

So, the net cost of this optimal collar was $352, or 1.82% of his position value.

One note 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 paid less than $352 when opening this collar.

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.