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  • An Update On Two ABX Hedges 0 comments
    Jun 26, 2013 7:23 PM | about stocks: ABX

    How You Could Have Hedged Your ABX Shares

    In an article in early May ("Caution May Be Warranted With These Stocks"), we posted two inexpensive ways to hedge 1000 shares of Barrick Gold (NYSE:ABX) against a greater-than-20% drop over the next several months. With today's 8.26% drop, ABX has fallen 24.3% since May 2nd. In this post, we'll look at how those two hedges reacted to the drop in ABX.

    1) Optimal Put Hedge

    These were the optimal puts*, as of May 2nd's close, to hedge against a greater-than-20% drop in ABX between then and mid-October.

    As you can see at the bottom of the screen capture above, the cost of this put protection, as a percentage of position value, was 6.09%. Note that, to be conservative, the cost here was calculated using the ask price of the optimal puts. In practice, an investor can often buy puts for a lower price, i.e., some price between the bid and ask.

    How Those Optimal Puts Reacted To ABX's Drop

    The screen capture below shows how those optimal puts we showed back in May reacted to ABX's drop as of Wednesday's close.

    As you can see in the screen capture above, those puts jumped more than 35% intra-day Wednesday when ABX had dropped about 8% by the same time. This is an example of the nonlinearity of options, which enables a small dollar amount of put options can protect a much larger position in an underlying security.

    How That Hedge Cushioned ABX's Drop

    ABX closed at $19.54 on May 2nd. An investor who owned 1000 shares and bought the optimal puts to hedge it against a >20% drop that day had $19,540 in ABX and an outlay of $1,200 on the puts (again, assuming, conservatively, that he bought the puts at the ask). $19,540 + $1,200 = $20,740.

    ABX closed at $14.78 today, and those puts closed at $2.99. As of today's close, our investor's ABX shares were worth $14,780 and his put options were worth $2,990: $14,780 + $2,990 = $17,770. $17,770 represents a drop of 14.3% from $20,740.

    So, although ABX dropped more than 24.3% from May 2nd's close to today's close (June 26th), an investor who bought those puts on May 2nd was only down about 14.3% on his combined hedge + underlying stock position over the same time frame.

    More Protection Than Promised

    Recall that the optimal put hedge was designed to protect against a greater-than-20% decline. Because these puts had plenty of time value in addition to intrinsic value as of June 26th's close, they offered more protection than that.

    2) Optimal Collar Hedge

    This was the optimal collar**, as of May 2nd's close, to hedge 1000 shares of ABX against a greater-than-20% drop between then and October 18th, while capping potential upside at 20% over the same time frame.

    As you can see at the bottom of the screen capture above, the net cost of this optimal collar was 0.05%.

    How That Optimal Collar Reacted To ABX's Drop

    The screen capture below shows how the put leg of that collar reacted to ABX's drop as of Wednesday's close.

    And here is how the call leg of that collar reacted:

    How That Hedge Cushioned ABX's Drop

    Recall ABX closed at $19.54 on May 2nd. An investor who owned 1000 shares and bought the optimal collar to hedge it against a >20% drop that day had $19,540 in ABX and a net outlay of $10 on the collar (again, assuming, conservatively, that he bought the puts at the ask and sold the calls at the bid). $19,540 + $10 = $19,550.

    ABX closed at $14.78 today, the puts in that optimal collar closed at $2.58, and the calls in that optimal collar closed at $0.18. As of today's close, our investor's ABX shares were worth $14,780 and his put options were worth $2,580, and if he wanted to close out the short call leg of his collar, it would cost him $180. So: (14,780 + $2,580) - $180 = $17,180. $17,180 represents a 12.1% drop from $19,550.

    So, although ABX dropped more than 24.3% from May 2nd's close to today's close (June 26th), an investor who bought those puts on May 2nd was only down about 12.1% on his combined hedge + underlying stock position over the same time frame.

    More Protection Than Promised

    Recall that the optimal collar hedge was designed to protect against a greater-than-20% decline. As of June 26th, they limited a hedged investor to a 12.1% drop when the underlying had dropped by more than 24%.

    *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 PhD 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 screen captures above come from the Portfolio Armor iOS app.

    Stocks: ABX
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