Hedging Wal-Mart After Its Post-Earnings Spike

| About: Wal-Mart Stores, (WMT)

Summary

Wal-Mart was the anti-Target this week, posting its best one-day performance in years after its earnings beat on Thursday.

Wal-Mart blew past the median Wall Street 12-month price target for the stock in one day, and outpaced our site's more bullish potential return estimate as well.

With concerns about a possible Fed rate hike this summer weighing on markets, we look at a couple of hedging Wal-Mart after its big move.

AP photo in the disturbing NYDN article that came up when I searched for my local WMT store ( http://www.nydailynews.com/news/crime/trucker-arrested-masturbating-urinating-walmart-article-1.2642795 )

Wal-Mart Versus The Efficient Market Hypothesis

Maybe the market isn't always efficient, even for mega-cap stocks. Prior to its earnings beat on Thursday, the median Wall Street analyst's 12-month price target for Wal-Mart (NYSE:WMT) was $65, a 2.9% gain over its closing price Wednesday. That median price target hadn't been updated yet as of Thursday, so you can see the contrast between it and Wal-Mart's best one-day performance in years in the screen capture below.

On Wednesday, the Portfolio Armor website was more bullish on Wal-Mart than Wall Street, estimating a potential return of 6% for the stock over the next six months. We found it interesting that our automated system was more bullish on Wal-Mart pre-earnings than the median Wall Street analyst - perhaps because they were concerned by troubling news from retail competitors such as Target (NYSE:TGT)? Our system had revised its potential return estimate for Wal-Mart over the next several months down to 4.6% after Thursday's big move.

Adding Downside Protection To Wal-Mart

For Wal-Mart longs who want to take advantage of the upward move to add some downside protection, we'll look at a couple of ways of doing so below. If you'd like a refresher on hedging terms first, please see the section titled "Refresher On Hedging Terms" in our recent article on hedging Disney.

Hedging Wal-Mart With Optimal Puts

We'll use Portfolio Armor's iOS app to find an optimal put and an optimal collar hedge for Wal-Mart, but you don't need the app for that. You can find optimal puts and collars yourself by using the steps in this article if you're willing to 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 600 shares of WMT against a greater-than-13% drop by mid-December.

As you can see at the bottom of the screen capture above, the cost of this protection was $1,188, or 2.86% of position value. A few points about this hedge:

  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 WMT position would be down 10.14%, not including the hedging cost.
  3. The threshold is based on the intrinsic value of the puts, so they may provide more protection than promised if the underlying security declines in the near term, when the puts may still have significant time value.

Hedging Wal-Mart With An Optimal Collar

When scanning for an optimal collar, you'll need one more number 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 4% over that time frame, then it might make sense to use 4% 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.

Since we didn't have updated Wall Street price targets for the stock on Thursday, and Wal-Mart had shot past the previous median price target already, we used the potential return our site estimated for it, 4.6%, as a cap. You can use a higher cap if you're more bullish, but, all else equal, that will raise your hedging cost.

As of Thursday's close, this was the optimal collar to hedge 600 shares of WMT against a greater-than-13% drop by mid-December while not capping an investor's upside at less than 4.6% by the end of that time period.

As you can see in the first part of the optimal collar above, the cost of the put leg was $876, or 2.11% 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 a bit higher: $364, or 1.73% of position value.

So, the net cost was negative, meaning an investor opening this collar would have collected an amount equal to $408, or -0.98% of position value. Two notes on this hedge:

  • Similar to the situation with the optimal puts, 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 $408 when opening this collar.
  • As with the optimal puts above, this hedge may provide more protection than promised if the underlying security declines in the near future due to time value (for an example of this, see this recent article on hedging Apple (NASDAQ:AAPL)). However, if the underlying security spikes in the near future, time value can have the opposite effect, making it costly to exit the position early (for an example of this, see this article on hedging Facebook (NASDAQ:FB) - Facebook Rewards Cautious Investors Less).

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.