Dark Pool Short Volume Just Quadrupled For Ford

| About: Ford Motor (F)


Although most stocks were down in the wake of Brexit on Friday, not many saw spikes as high as Ford in dark pool shorting.

The volume of dark pool shorting in Ford was 4.3x normal on Friday.

For Ford longs looking to add downside protection, we present a couple of ways of doing so.

A model demonstrates an adaptive airbag. Via Automotive.com: http://www.automotive.com/news/trw-improves-safety-with-introduction-of-next-generation-adaptive-airbag-68461/ Click to enlarge

Crash Protection For Ford After Dark Pool Short Volume Spike

If you were unfazed by Friday's drop in Ford (NYSE:F), consider the automated email we received from SqueezeMetrics that day:

Hey there,

Looks like there was some unusual dark pool activity in some of the tickers you follow.

F had 4.3x more dark pool shorting than usual.

Dark pools, for readers who may be unfamiliar with the term, are private exchanges where institutions trade shares without the transparency of public markets. This enables them to place large block trades away from front-runners and other predatory traders on public exchanges. Seeking Alpha contributor SqueezeMetrics elaborated on how dark pools work, and why investors should pay attention to them, in an article earlier this year, Seeking Alpha In The Dark.

After seeing that email from SqueezeMetrics, I signed on to their site and pulled up the chart below. The red part of the histogram represents the volume of dark pool shorting, and you can see how that spiked on June 24th.

Screen Capture via Squeeze Metrics Click to enlarge

A Brexit Effect?

A question that may come to mind for readers is whether this was in some way related to Brexit - after all, most stocks plummeted after the vote. That's true, but bear in mind that dark pool short interest didn't spike for most stocks on Friday. We follow dozens of widely-held stocks on Squeeze Metrics, and Ford was one of only two to see a large spike in dark pool interest that day (the other was Citigroup (NYSE:C), which had a 3.8x spike).

Adding Downside Protection To Ford

If you're long Ford and are still generally bullish on it, but you want to limit your downside risk in light of the spike in short interest, we'll look at two ways of hedging it over the next several months below. If you'd like a refresher on hedging terms first, please see the section titled "Refresher On Hedging Terms" in this previous article of ours, Locking In Gold Gains.

Hedging F With Optimal Puts

We're going to use Portfolio Armor's iOS app to find optimal puts and an optimal collar to hedge FB 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 11%. If you are less risk-averse, you could use a larger one. All else equal, the higher the threshold, the cheaper it will be to hedge.

Here are the optimal puts, as of Friday's close, to hedge 600 shares of F against a greater-than-11% drop by mid-December.

As you can see at the bottom of the screen capture above, the cost of this protection was $510 or 6.79% 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 11% threshold includes this cost, i.e., in the worst-case scenario, your F position would be down 4.21%, 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 F With An Optimal Collar

When scanning for an optimal collar, you'll need another 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. One starting point for the cap is your estimate of how the security will perform over the time period of the hedge - 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 F'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. Ford didn't pass, though, so we used the potential return implied by the median (12-month) Wall Street price target shown below (via Yahoo Finance), which was about 10%.

As of Friday's close, this was the optimal collar to hedge 600 shares of F against a greater-than-11% drop by mid-December, while not capping an investor's upside at less than 10%.

As you can see in the first part of the optimal collar above, the put leg is the same as in the optimal puts above, so the cost is the same: $510 or 6.79% 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 $156, or 2.08% of position value.

So the net cost of this optimal collar was $354, or 4.71% of position value. A few 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 paid less than $354 when opening this collar.
  • 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). 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 - Facebook Rewards Cautious Investors Less).
  • Sometimes optimal collars eliminate most or all of the cost of hedging. Not so here. If you have a higher risk tolerance and a more modest potential return estimate for Ford, you may want to try scanning for a less expensive hedge by using a higher threshold and a lower cap.

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.