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David Pinsen
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I founded Launching Innovation, LLC, to bring together developers, designers, and academic finance experts to create easy-to-use tools to solve complex problems for investors.
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Portfolio Armor
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  • How An Inexpensive Hedge Could Have Helped AFFY Longs 2 comments
    Mar 19, 2013 9:06 PM | about stocks: AFFY

    How A $50 Hedge Could Have Saved $2,470

    Shares of Affymax, Inc. (OTCPK:AFFY) plummeted 64% on Tuesday after the company announced late Monday that it was letting go 75% of its workforce. AFFY is now down 70% since March 7th, but an AFFY long who opened this optimal collar hedge then would only be down 12% over the same time frame (granted, he would have been much better off hedging a month earlier). For an investor who owned 1,000 shares of AFFY, opening that collar would have cost $50, and it would have saved him $2,470 in downside on his shares. In this post, I'll show how that hedge worked.

    Hedging AFFY After Its Dead-Cat Bounce Two Weeks Ago

    News of a drug recall last month caused AFFY shares to plummet from a price of over $16 to under $2.50 in late February, but the stock had what now appears to be a dead cat bounce on March 7th, rising 54% to close at $3.52. At the time, we noted on StockTwits that, despite the stock's jump, it was still too expensive to hedge against a >20% drop with optimal puts*. As the screen capture below shows, the cost of that level of put protection on AFFY on March 7th was greater than that 20% decline threshold.

    Too Expensive To Hedge With Optimal Puts

    Not Too Expensive To Hedge With An Optimal Collar

    In a subsequent message on March 7th, we mentioned AFFY wasn't too expensive to hedge against the same >20% with an optimal collar**, if an investor was willing to cap his upside by the same percentage over the same time frame. The screen capture below shows the optimal collar, as of March 7th, to hedge 1000 shares of AFFY against a greater-than-20% drop over the next several months.

    As you can see at the bottom of the screen capture above, the net cost of this collar was $50, or 1.42% of position value. Note, too, that the ask price on the put leg of this collar was $0.95 per contract. As the screen capture below shows, those puts traded for $2.05 on March 19th.

    That Collar's Puts On March 19th

    How That Collar Cushioned Tuesday's AFFY Crash

    An investor who owned 1000 shares of AFFY on March 7th and opened the optimal collar above to hedge it against a >20% drop that day had $3,520 in stock and an outlay of $50 for his hedge. $3,520 + $50 = $3,570

    As of Tuesday, March 19th's close, his AFFY shares were worth $1,050 and the put leg of his optimal collar was worth $2,050: $1,050 + $2,050 = $3,100. So although AFFY dropped 70% from March 4th's close to March 19th's close, an investor who opened this collar on March 4th was only down about 12% on his combined hedge + underlying stock position over the same time frame

    More Protection Than Promised

    Recall that the optimal collar above was designed to protect against a greater-than-20% decline. Because the puts in this collar had plenty of time value in addition to intrinsic value as of March 19th's close, they offered more protection than that.

    *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 stocks and ETFs, scanning for the optimal ones.

    **Optimal collars are the ones that will give you the level of protection you want at the lowest net cost, while not limiting your potential upside by more than you specify. The algorithm to scan for optimal collars was developed in conjunction with a post-doctoral fellow in the financial engineering department at Princeton University. The first two screen captures above come from the Portfolio Armor iOS app.

    Stocks: AFFY
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Comments (2)
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  • mershaw2001
    , contributor
    Comments (111) | Send Message
     
    Anyone who was long expected the stock to rise from 4 dollars up to the 20's again. Why would you possibly collar a stock with over 400% potential return in the forward month?
    Two things are essential for options: being able to eliminate possible future events, and then choosing the right contracts in order to play on that knowledge. You've eliminated any upside for the stock, which I think at the time of the drop, would have been a mistake.
    5 Jun 2013, 04:30 PM Reply Like
  • David Pinsen
    , contributor
    Comments (1073) | Send Message
     
    Author’s reply » I can't claim to know the thoughts of "anyone who was long" AFFY at the time I wrote this post. Yes, capping potential upside can be a trade-off of collars. But in the example above, if the investor were still bullish on AFFY after it dropped 70%, he could have sold his appreciated puts then and the used some of the proceeds to buy to close his calls (which would have cost very little at that point), eliminating his upside cap, and then used the rest of his put proceeds to buy more of the stock for the ride up.
    6 Jun 2013, 10:36 AM Reply Like
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