Preparing For A Drop In Priceline

| About: The Priceline (PCLN)

Summary

Priceline's share price history since its IPO illustrates how difficult it can be to hold onto what turned out to be a great stock.

A comparison with Cisco illustrates how hard it is to determine what will end up being the better stock years later.

One, imperfect, response to such uncertainty is hedging. We present two hedges for Priceline.

Screen capture via Bing Click to enlarge

Many shall be restored that now are fallen and many shall fall that now are in honor. -- Horace, Ars Poetica

The Cost Of Not Hedging

For years I cringed at those silly Priceline (NASDAQ:PCLN) commercials starring William Shatner. They were painful reminders of one of my worst investing decisions. The story starts in the late 1990s. After an initial, mistaken focus on valuation (buying 3Com instead of Cisco (NASDAQ:CSCO) because it looked cheaper), I had finally gotten the hang of dot-com investing. When Priceline went public, I didn't think of valuation at all. I thought of how its clean, two-syllable name went well with "dot-com". Easy to remember, easy to say, easy to type to get to the website.

So I bought PCLN about a week after its IPO, if memory serves, for about $80 per share. Soon after, it doubled. I held.

I ended up selling in the mid-teens in 2001 or 2002, missing out on the ~8,000% return since then.

I did a search before writing this to refresh my memory about the date of Priceline's IPO, and I came across this Forbes article from February of 2001 which must have seemed self-evidently true at the time: Pop Goes The IPO. Check out this paragraph:

Caught up in the Internet frenzy, they paid absurd prices for such dubious issues as Priceline.com in hopes that they were buying the next Cisco Systems. Now, amid the rubble of the dot-com collapse, many investors have sworn off IPOs entirely.

Here's a chart showing how Cisco and Priceline had performed from Priceline's IPO in early 1999 to the time that article was published in early 2001:

Screen capture via YCharts

And here's a chart of how both stocks have performed since:

Screen capture via YCharts

I can't honestly say for sure I would have held Priceline until now if I had been hedged (if I had been hedged with a collar, I might have had the stock called away). But I can say that I could have avoided a >90% if I had been hedged.

The broader point here is that no one knows what the future holds for particular stocks. Benjamin Graham signaled this in the very beginning of his classic Security Analysis, with his use of the Horace quote above. With that in mind, let's look at a couple of ways of hedging Priceline below. If you'd like a refresher on hedging terms first, please see the section titled "Refresher On Hedging Terms" in this previous article, Locking In Gold Gains.

Hedging PCLN With Optimal Puts

I used Portfolio Armor's iOS app to find optimal puts and an optimal collar to hedge PCLN below, but you don't need the app for that. You can find optimal puts and collars yourself by using the process I outlined 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 14%. 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 Tuesday's close, to hedge 100 shares of PCLN against a greater-than-14% drop by late January.

As you can see at the bottom of the screen capture above, the cost of this protection was $5,430 or 4.04% 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 14% threshold includes this cost, i.e., in the worst-case scenario, your PCLN position would be down 9.96%, 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 PCLN 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 PCLN'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. Priceline passed, and the site estimated a potential return of 24% for it over 6 months. That was higher than the 6-month potential return of about 6% implied by the Wall Street consensus 12-month price target for the stock (screen captured via NASDAQ below).

Screen capture via Nasdaq. Click to enlarge

So, instead of using either of those numbers as the cap, I used 12%, as that was the highest cap at which the cost of the collar was negative.

As of Tuesday's close, this was the optimal collar to hedge 100 shares of PCLN against a greater-than-14% drop by late January, while not capping an investor's upside at less than 12% by then.

As you can see in the first part of the optimal collar above, the cost of the put leg was $4,080, or 3.03% 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 $4,560, or 3.39% of position value.

So the net cost of this optimal collar was negative, meaning an investor opening it would have collected an amount equal to $480, or 0.36% of position value. A couple of notes on this hedge:

  • Similar to the case 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 $480 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).

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.