Hedging Five First Call Consensus "Strong Buys"
First Call Consensus Recommendations are provided by Thomson Reuters, which aggregates recommendations by other providers and applies them to a standardized, a five-point scale:
- Strong Buy
- Strong Sell
On Wednesday, among optionable stocks with trading volumes of 2 million shares or more, there were 13 First Call Consensus "Strong Buys". The most actively-traded of these Strong Buys was Banco Santander, SA (STD), which came as a surprise to me, given the Spanish multinational bank's significant exposure to Europe. Judging by the current cost of hedging it, options investors are more bearish about Santander's prospects then the analysts responsible for the company's "Strong Buy" First Call Consensus Recommendation.
The table below shows the costs of hedging Banco Santander and three other of the most actively-traded First Call Consensus Strong Buy Recommendations against greater-than-24% declines over the next several months, using optimal puts.
For comparison purposes, I've added the SPDR S&P 500 ETF (SPY) to the table. First, a reminder about what optimal puts are, and an explanation of the 24% decline threshold. Then, a screen capture showing the optimal put to hedge the one of the First Call Consensus Strong Buys, Berkshire Hathaway, Inc. (BRK.B).
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.
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% thresholds when hedging equities, but one of these stocks was too expensive to hedge using a 20% threshold (i.e., the cost of hedging it against a greater-than-20% drop was itself greater than 20%, so Portfolio Armor indicated that no optimal contracts were found for it). There were optimal contracts available for all of these names using a decline threshold of 24%, so that's the threshold I've used below.
The Optimal Puts to BRK.B
Below is a screen capture showing the optimal put option contract to hedge 100 shares of Berkshire Hathaway against a greater-than-24% decline as of Wednesday's close. A note about this optimal put and its cost: To be conservative, the app calculated the cost based on the ask price of the optimal put. In practice an investor can often purchase puts for a lower price, i.e., some price between the bid and the ask (the same is true of the other names in the table below).
Hedging Costs As Of Wednesday's Close
The hedging costs below are presented as percentages of position value. Aside from the comparison ETF SPY, listed at the bottom, the stocks appear in descending order of their trading volumes Wednesday, with the most actively-traded of these stocks, Banco Santander, listed first. Given the high cost of hedging a few of these names, if you own them as part of a diversified portfolio, and are content to let that diversification ameliorate your stock-specific risk - but are still concerned about market risk - you might consider buying optimal puts on an index-tracking ETF (such as SPY) instead, as a way to hedge your market risk.
|STD||Banco Santander, SA||19.1%*|
Hertz Global Holdings, Inc.
|SPY||SPDR S&P 500||2.08%*|
*Based on optimal puts expiring in December
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.