Would You Like Some Downside Protection With That?
Last time we looked at adding downside protection to McDonald's (NYSE:MCD), it was early April: The stock was up about 40% from its August lows, fueled by the company's switch to serving breakfast all day.
But Seeking Alpha contributor Long/Short Trader made a short case for it, based on valuation (one of these 23 "best ideas").
Flash forward to the end of May. McDonald's is down about $4 per share since early April, and we have another Seeking Alpha contributor raising a warning about it; this time Alex Pitti (pictured below; image via his Twitter account)
In his article (McDonald's Could Crash), Pitti also raises valuation concerns, and he pairs that with his prediction of a coming global economic slowdown. He sees that as a potentially dangerous combo for McDonald's longs.
Staying Long MCD While Hedging Against A Crash
For McDonald's shareholders who are still bullish on the stock after reading Alex Pitti's warning, but want to limit their downside risk in case he ends up being right, we look at two ways of protecting yourself over the next several months by adding a side of hedging. 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 (NYSE:DIS).
Hedging MCD With Optimal Puts
We're going to use Portfolio Armor's iOS app to find optimal puts and an optimal collar to hedge MCD 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 math.
Whether you run the calculations yourself using the process we outlined or use the app, another piece of information you'll need to supply (along with the number of shares you're looking to hedge) when scanning for optimal puts is your "threshold," which is 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 14%. 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 larger the threshold, the cheaper it will be to hedge.
Here are the optimal puts as of Wednesday's close to hedge 500 shares of MCD against a greater than 14% drop by mid-December.
As you can see at the bottom of the screen capture above, the cost of this protection was $1,465, or 2.38% of position value. A few points about this cost:
- To be conservative, the cost was based on the ask price of the puts. In practice, you can often buy puts for less (at some price between the bid and ask).
- The 14% threshold includes this cost, i.e., in the worst-case scenario, your MCD position would be down 11.62%, not including the hedging cost.
- 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.
If you don't want to spend this much to hedge against a greater than 14% decline over the next several months, you can consider hedging with an optimal collar instead.
Hedging MCD 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 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.
We checked Portfolio Armor's website to get an estimate of MCD's potential return over the next several months. 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, a high-end estimate. In the case of MCD on Wednesday, the site calculated a potential return of 9%. That was more bullish than the 5.5% return over the same time frame implied by the median (12-month) Wall Street price target of $135, screen captured below, via Yahoo.
So we used the more bullish 9% estimate as the cap.
This was the optimal collar, as of Wednesday's close, to hedge 500 shares of MCD against a >14% drop by mid-December, while not capping an investor's upside at less than 9% by then.
As you can see in the first part of the collar above, in this case, the put leg is at the same strike as the optimal put above, so the cost is the same: $1,465, or 2.38% of position value. But as you can see in the second part of the collar below, the income generated from the call leg was $710, or 1.15% of position value.
So the net cost of this collar was $755, or 1.23% of position value. A couple of notes about 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 paid less than $755 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.