3 Out of 5 Top-Performing Mid Caps Are Biotechs
Among optionable mid cap stocks with daily trading volumes of over one million shares, five were up more than 60% year-to-date, as of intraday Tuesday. Despite the headwinds facing the biotech industry (which we discussed in a recent article, "Hedging Biotechs As R&D Spending Declines), three of those five top-performing mid caps were biotech stocks -- Amylin Pharmaceuticals, Inc. (AMLN), Vivus, Inc. (VVUS), and Human Genome Sciences, Inc. (HGSI).
Of those biotech stocks, one in particular -- Vivus, Inc. -- was quite expensive to hedge. Recall that we have observed examples of high optimal hedging costs presaging poor performance. Vivus expects the Food and Drug Administration to announce on or before July 17th whether or not it has approved Vivus's obesity drug Qnexa; the company expects a decision on the drug by European regulators no sooner than September (when Vivus is scheduled to meet with a European regulatory panel).
The table below shows the costs, as of intraday Tuesday, of hedging Vivus, Inc, Amylin Pharmaceuticals, Human Genome Sciences, and two other top-performing mid caps against greater-than-29% declines over the next several months, using optimal puts.
For comparison purposes, I've added the iShares S&P MidCap 400 Index ETF (IJH) and the PowerShares QQQ Trust ETF (QQQ) to the table. First, a reminder about what optimal puts are, and an explanation of the 29% decline threshold; then, a screen capture showing the optimal put to hedge one of the biotech stocks below, Amylin Pharmaceuticals, Inc. (AMLN).
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 the algorithm indicated that no optimal contracts were found for it). The smallest decline threshold for which there were optimal puts for all these securities was 29%, so that's the threshold I've used for all of the names below.
The Optimal Puts to Hedge AMLN
Below is a screen capture showing the optimal put option contract to buy to hedge 100 shares of Amylin Pharmaceuticals against a greater-than-29% drop between now and January 18th. A note about this optimal put option and its cost: To be conservative, the app 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 (the same is true of the other names in the table below).
Hedging Costs as of Intraday Tuesday
The hedging costs below are as of Tuesday afternoon, and are presented as percentages of position values. Year-to-date performance numbers are as of intraday Tuesday as well. As we noted above, one of these stocks, VVUS, has extremely high hedging costs. Note also that the mid cap index-tracking ETF, IJH is quite expensive to hedge now. If you own VVUS 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 may want to consider buying optimal puts on a broader market index-tracking ETF (such as QQQ) instead, as a way to hedge your market risk.
|HGSI||Human Genome Sciences, Inc.||82.1%||7.93%***|
|TRIP||Trip Advisor, Inc.||64.6%||10.2%**|
|IJH||iShares S&P MidCap 400||1.76%||8.24%*|
*Based on optimal puts expiring in November
**Based on optimal puts expiring in December
***Based on optimal puts expiring in January
Additional disclosure: I am long optimal puts on QQQ as a hedge against market risk.