Back in January (Einhorn Shorted Amazon - You Shouldn't), we argued that although hedge fund manager David Einhorn had shorted Amazon (NASDAQ:AMZN), investors shouldn't follow his lead. On the contrary, we suggested investors consider buying Amazon, which was a top-ranked name on the Portfolio Armor website, provided they hedged to limit their downside risk.
In that article, we noted that Jeff Bezos (pictured below, accompanying his newly freed Washington Post reporter Jason Rezaian back from Iran - image via NBC Nightly News) had a better 2015 than value investor David Einhorn.
In a follow up article, after Amazon reported disappointing 4Q 2015 earnings (Advantage Einhorn?) we discussed courses of action for hedged Amazon shareholders. We concluded that they were likely best off staying the course:
In our view, and in light of Portfolio Armor's updated potential return on AMZN (16%, down from 30% pre-Q4 earnings), staying the course would seem to make the most sense now. Since the hedge doesn't expire until July, you can hold the position through the next earnings release. Given that the cap on the collar is far above our updated potential return, it probably doesn't make sense to buy-to-close the call leg now. This is also consistent with our research as part of our backtesting the hedged portfolio method. We found that, on average, the highest returns came from holding securities for six months, or until just before their hedges expired, whichever came first. Essentially, this gave the underlying securities more time to recover from declines and generate better performance.
Shares of Amazon have done just that, after bottoming out in February, as the chart below shows.
Bezos has certainly had a better April than Einhorn. Einhorn's portfolio holding SunEdison (NYSE:SUNE) filed for bankruptcy, and then, the following week, Amazon reported a great quarter, summarized by the Fast Company graphic below.
What Happens To Hedges When A Stock Goes Up
In our previous article on the post-earnings spike in Facebook (NASDAQ:FB) shares (Facebook Rewards Cautious Investors Less), we looked at how hedges on that stock reacted as Facebook spiked after earnings. As we noted in that article, a sharp move up in a stock can make it costly to exit a collared position early:
As with the optimal puts above, this (optimal collar) hedge may provide more protection than promised if the underlying security plummets in the near future due to the put leg's combination of intrinsic value and time value (for an example of this, see the section titled "More Protection Than Promised" in this article). However, if the underlying security spikes in the near future, the combined time value and intrinsic value of the call leg can have the opposite effect, making it costly to exit the position early.
There's an interesting difference between the Amazon and Facebook examples, as we'll see below. In the case of Facebook, the hedge had a negative cost, but there was a drag on returns due to the time value of the call leg. In the case of Amazon, most of the time value of both legs of the hedge has evaporated, so the drag on returns is due mainly to the initial (positive) hedging cost.
Status Of The January 22nd Optimal Collar Hedge
As of January 22nd's close, this was the optimal collar to hedge 100 shares of AMZN against a greater-than-15% drop by mid-July, while not capping an investor's upside at less than 30% by the end of that time period (the screen capture below is via the Portfolio Armor iOS app).
As you can see above, the cost of this hedge was $2,705, or 4.54% of position value.
Here's an updated quote on the put leg as of Friday's close:
And here is an updated quote on the call leg:
How That Hedge Reacted To Amazon's Rise
AMZN closed at $596.38 on Friday, January 22nd. A shareholder who owned 100 shares of it and hedged with the collar above then had $59,638 in AMZN stock plus $3,460 in puts, and if he wanted to buy-to-close his short call position, he would have needed to pay $755 to do that. So, his net hedged position value on January 22nd was ($59,683 + $3,460) - $755 = $62,343.
AMZN closed at $659.59 on Friday, April 29th, up 10.6% from its closing price on January 22nd. The investor's shares were worth $65,959 as of 4/29, his put options were worth $375, and if he wanted to close out the short call leg of his collar, it would have cost him $167. So, ($65,959 + $375) - $167 = $66,167. $66,167 represents a 6.1% gain from $62,343.
Cost Of Exiting Early
So, although AMZN was up by 10.6% at the time of the calculations above, if the investor hedged with this collar wanted to exit his position on Friday, his gain would have been limited to 6.1%. Note that the difference there (4.5%) is within 4 basis points of the initial hedging cost (4.54%). This makes sense as most of the time value of the put options has evaporated (the same is true of the call options on the debit side, but the investor paid about 4.6x more for the puts than he received for selling the calls in January).
Best- And Worst-Case Scenarios
The best-case scenario here is Amazon keeps going up and is up 30% or more from the January 22nd closing price by mid-July. In that case, the investor would be up about 25.5% from the January 22nd closing price, net of his hedging cost. The worst-case scenario is Amazon plummets from here, and the investor is down no more than 15% from the January 22nd closing price by mid-July. That maximum decline includes the hedging cost (i.e., not counting the hedging cost, the investor would be down about 10.5%).
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.
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