Before And After Pandora's Quarter: A Look At Hedging The Stock And Competitors

| About: Pandora Media (P)

After the close on Tuesday, Pandora Media (NYSE:P) announced its quarterly results and offered disappointing guidance, with the company anticipating continued losses for at least another year. The news sent the stock lower in after hours trading, and the stock opened significantly lower Wednesday morning. The screen capture below, showing a Pandora stock quote from intraday Wednesday, is instructive, as it highlights a limitation of stop loss orders in situations like this.

Note from the quote above that Pandora opened Wednesday down more than 23% from its close on Tuesday. This is an example of a "gap down" in price for a stock. Consider the case of an investor who owned Pandora on Tuesday and had a stop loss order on it set for 10% below its then-current price. He wouldn't have gotten out for just a 10% decline on Wednesday. His order would have triggered at the open for a decline of more than 23% from the previous closing price. Something to bear in mind when using stop orders.

Hedging Pandora, before and after the market's reaction to its quarter

After the news Tuesday afternoon, I took a screen capture of the optimal puts to hedge Pandora against a greater-than-22% drop over the next several months. Those optimal puts were as of Tuesday's close, before Pandora's quarter was released. I wanted to see how the cost of hedging would change in response to the news.

As it happened, the hedging cost as a percentage of position changed only slightly (extremely expensive in both cases), though, of course, the optimal puts to hedge against a 22% drop on Wednesday were different ones, as they represented protection from a significantly lower starting share price in the underlying stock. I've included both screen captures below, along with a table showing the current costs of hedging four of Pandora's competitors - Sirius XM Radio Inc. (NASDAQ:SIRI), and three tech giants that offer their own music services - against the same declines. First, though, a reminder about what optimal puts are, and a note about why I've used 22% decline thresholds here.

About Optimal Puts

Optimal puts are the ones that will give you the level of protection you want at the lowest possible cost. Portfolio Armor uses an algorithm developed by a finance Ph.D. to sort through and analyze all of the available puts for your position, scanning for the optimal ones.

Decline Thresholds

In this context, "threshold" refers to the maximum decline you are willing to risk in the value of your position in a security. You can enter any percentage you like for a decline threshold when scanning for optimal puts (the higher the percentage though, the greater the chance you will find optimal puts for your position). Often, I use 20% decline thresholds when hedging, but Pandora was too expensive to hedge using a 20% decline threshold on Tuesday (i.e., the cost of hedging it against a greater-than-20% drop was itself greater than 20% of position value, so the app indicated no optimal contracts were found for it). There were optimal contracts available for it using a 22% threshold, so that's the threshold I used for it as well as for the other names in the table below.

The optimal puts to hedge P on Tuesday

Below is a screen capture showing what was the optimal put option contract to buy to hedge 100 shares of Pandora against a greater-than-22% drop as of Tuesday's close (before Pandora's quarter was released). A note about optimal put options and their cost: To be conservative, Portfolio Armor calculated the cost based on the ask price of the optimal puts. In practice an investor can often purchase puts for a lower price, i.e., some price between the bid and the ask.

How the Put Option Contract Above Reacted on Wednesday

After Pandora's 23% drop, on Wednesday morning the put option contract above was trading with a bid-ask spread of $3.80 by $4.10. That means that an investor owning the optimal puts above could have sold them for at least $3.80. Had the investor soured on Pandora Wednesday, he could have sold both his stock and his puts, with the gain on the puts ameliorating a small amount of his loss on the stock. If the investor were still bullish on Pandora Wednesday, he could have held the stock and those puts, knowing that his put protection would continue to limit his downside for several months. Alternatively, he could have sold his appreciated puts and bought more of the underlying stock at its new, lower price.

The optimal puts to hedge P on Wednesday

Below is a screen capture showing the optimal put option contract to hedge 100 shares of Pandora against the same percentage decline as of intraday Wednesday. Note that this is a different put option contract, with a lower strike price than the one in the screen capture above, as this is a hedge against a 22% drop from Wednesday's significantly lower share price.

Competitors' Hedging Costs As of Wednesday Afternoon

The hedging costs below are as of intraday Wednesday, using 22% decline thresholds, and are presented as percentages of position value. For comparison purposes, in addition to Pandora's competitors, I've included the SPDR Select Sector - Technology ETF (NYSEARCA:XLK) to the table.



Cost of Protection

P Pandora Media, Inc. 18.8%*
GOOG Google, Inc. 1.87%*
SIRI Sirius XM Radio Inc. 7.56%*
AMZN, Inc. 5.44%**
AAPL Apple Inc. 3.10%**
XLF SPDR Select Sector -- Tech 1.74%*
Click to enlarge

*Based on optimal puts expiring in September.

**Based on optimal puts expiring in October.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.