Locking In Relypsa Gains
Shares of Relypsa (NASDAQ:RLYP), maker of the hyperkalemia treatment Veltassa (pictured above), spiked 67% Thursday on another buyout rumor, before sliding back about 7.5% on Friday. Relypsa investors who entered their positions near the stock's March low are now up over 81%. For those and other Relypsa longs who are in the black now and interested in laying off some risk, you can, of course, unload some shares. But if you'd like to hold on to all of your shares in the hopes of adding some gains, we'll look at ways of hedging it below.
When it comes to hedging, Relypsa is similar to another pharmaceutical stock we looked at recently, Valeant Pharmaceuticals (NYSE:VRX). Like Valeant, Relypsa is prohibitively expensive to hedge with optimal puts over the next several months, but can be inexpensively hedged with an optimal collar. So we'll show an optimal put hedge for illustration purposes, but the optimal collar will be of more practical interest to RLYP longs. If you'd like a refresher on those and other hedging terms first, please see the section titled "Refresher On Hedging Terms" in this previous article of ours, Locking In Gold Gains.
Hedging RLYP With Optimal Puts
We're going to use Portfolio Armor's iOS app to find optimal puts and an optimal collar to hedge RLYP below, but you needn't use 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 math. 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 is the maximum decline you are willing to risk. This will vary depending on your risk tolerance. For this optimal put example, we've used a threshold of 28%, as that was the lowest threshold at which it was possible to hedge the stock over the next several months in this manner.
Here are the optimal puts as of Friday's close to hedge 400 shares of RLYP against a greater-than-28% drop by mid-September.
As you can see at the bottom of the screen capture above, the cost of this protection was $2,320, or 25.8% of position value. As we noted above, prohibitively expensive. Nevertheless, a couple of points about this cost:
- 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).
- The 28% threshold includes this cost, i.e., in the worst-case scenario, your RLYP position would be down 2.2%, not including the hedging cost.
Hedging RLYP 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 usual 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 several-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 anyway, so you're willing to sell someone else the right to call it away if it does better than that. But when a stock jumps nearly 70% in one day on a buyout rumor, estimating its future returns would seem to involve more guesswork than usual.
So, instead, we tried different inputs on the app to find a hedge that would provide at least as much protection as the put we showed above, but without the cost. And we found one using a cap of 20% and a threshold of 24%.
Here is the optimal collar, as of Friday's close, to hedge 400 shares of RLYP against a greater-than-24% decline by mid-September without capping an investor's upside at less than 20%.
As you can see in the first part of the collar above, the app was able to use a further out-of-the-money strike price for the put leg than in the optimal put hedge above, despite this hedge having a smaller threshold. That's because hedging cost impacts the selection process, and as you'll see below, the net cost of this hedge is radically different. The cost of the put leg above was $1,240, or 13.79% of position value. But as you can see in the second part of the collar below, the income generated from the call leg was a bit higher: $1,320, or 14.68% of position value.
So the net cost of this collar was negative, meaning, an investor would have collected an amount equal to $80, or 0.89% of position value when opening this hedge. One note on this 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 $80 when opening this hedge.