IBM Rallied - What To Do?

| About: International Business (IBM)

Summary

After riding the recent market rally, IBM jumped higher on news Thursday, including its upgrade by Morgan Stanley's Katy Huberty.

Nevertheless, it seems unlikely the stock's momentum will continue if the broader market resumes its downtrend. We note an indicator suggesting the downtrend may resume.

Given the uncertainty about market direction, we look at two ways of hedging IBM while its recent double rally makes it cheaper to do so.

IBM's Double Rally

Up until Wednesday's close, the recent rally in IBM Corp. (NYSE:IBM) appeared to be similar to the rally in Apple (NASDAQ:AAPL) we discussed in our previous article ("Hedging Tuesday's Apple Rally"). In both cases, the rallies appeared to have been more due to the recent global market rally than any company-specific news. That changed on Thursday: the market's three-day rally came to an end, but IBM shot up 5% after an upgrade by Katy Huberty of Morgan Stanley, who put a $140 price target on the stock, and news that IBM's Watson Health unit was acquiring healthcare analytics company Truven.

Still, it seems unlikely the stock's momentum will continue if the market as a whole trends down. So, as with Apple, a salient question here for IBM longs is whether the recent market rally will continue after Thursday's dip or if it has been more of a head fake before stocks trend down again.

We noted one indicator supporting the head fake thesis in our Apple article published on Wednesday: A portfolio manager's market warning based on valuation, market internals, and other factors. Bespoke Investment Group offered another indicator supporting that thesis on Wednesday via this tweet, a screen capture of which appears below.

That tweet was a follow-up to a previous one showing the same phenomenon: The stocks that have risen the most during the recent rally have been the ones with the highest short interest. That suggests the recent rally may have been more due to short squeezes than any material changes in outlook. As market technician Matt Blackman, CMT has noted (see #8), short squeezes occur more often during bear market rallies. But they occur during bull market rallies too. So, we're left with uncertainty.

Since hedging is a reasonable response to uncertainty, and the recent rally has made hedging less expensive, we'll look at a couple of ways of hedging IBM below (for a refresher on hedging terms, please see the section titled "Refresher On Hedging Terms" in our previous article on hedging Apple).

Hedging IBM With Optimal Puts

We're going to use Portfolio Armor's iOS app to find optimal puts and an optimal collar to hedge IBM 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 13%. 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 are the optimal puts as of Thursday's close to hedge 400 shares of IBM against a greater-than-13% drop by mid-July.

As you can see at the bottom of the screen capture above, the cost of this protection was $1,580, or 2.98% 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 13% threshold includes this cost, i.e., in the worst-case scenario, your IBM position would be down 10.02%, not including the hedging cost.

Hedging IBM 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 five-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 IBM's potential return over the time frame of the hedge. Every trading day, the site runs two 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. As with Apple, however, IBM didn't pass those two screens, so the site didn't calculate a potential return for it. So, instead, we used Katy Huberty's price target of $140, which represents a 5.7% increase from the stock's closing price on Thursday of $132.45. Generally Wall Street price targets go out one year, and we're hedging five months out here, so you could adjust that 5.7% figure down accordingly, but given IBM's strong move today, we figured we'd stick with that 5.7% figure.

As of Thursday's close, this was the optimal collar to hedge 400 shares of IBM against a greater-than-13% drop by mid-July, while not capping an investor's upside at less than 5.7%.

As you can see in the first part of the optimal collar above, the cost of the put leg was $1,164, or 2.20%, 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 $1,580, or 2.98% of position value.

So the net cost of this optimal collar was negative, meaning an investor would have collected $416 more from selling the call leg than he paid for the puts, an amount equal to 0.79% 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 $416 when opening this collar.
  2. Although the threshold on this collar is 13%, 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 13%: assuming, conservatively, a negative cost of 0.79%, the maximum drawdown here would be 12.21%. Similarly, the best-case scenario wouldn't be 5.7%, the level at which this collar is capped, but slightly higher: 5.7% + 0.79% = 6.49%.

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.