Hedging Against the Bursting of Internet Bubble 2.0

by: David Pinsen

A conversation I had earlier this week with New York-based Internet entrepreneur Jesse Middleton, co-founder of GetMinders and WeWork Labs (and former director of IT at LivePerson, Inc.) prompted me to think about the current Internet bubble and how one might hedge against the bursting of it with protective puts. Jesse had recently returned from the South by Southwest conference, from which he sent this memorable tweet:

That tweet, and our discussion about it, got me to thinking about hedging in the context of the New Internet Bubble. Consider the case of a business owner whose revenues were closely tied to the fortunes of privately held, venture-backed start-ups in the sector: he couldn’t hedge against a collapse in those companies directly, but he could buy put protection against a big correction in some publicly traded securities in the Internet sector, as an indirect hedge. A couple of ideas came to mind:

Buying puts on Internet ETFs

Judging by their top 10 holdings, the First Trust Dow Jones Internet Index ETF (NYSEARCA:FDN), is more diversified than the Merrill Lynch Internet HOLDRs ETF (NYSE:HHH), which has nearly 40% of its assets in Amazon.com (NASDAQ:AMZN). Below are the put option contracts Portfolio Armor presented as the optimal ones to hedge against greater-than-25% declines in these ETFs, but first a quick reminder about what “optimal” means in this context: The optimal put option contracts are the ones that will give you the precise level of protection you want at the lowest possible cost. Portfolio Armor uses a proprietary algorith developed by a finance Ph.D. candidate to find the optimal contracts to hedge stocks and ETFs.

(Click graphics to enlarge)

One note about the wide difference between the “initial cost” and “current value” shown for the optimal put option contract for FDN: to be conservative, Portfolio Armor uses the “ask” to calculate initial cost (“current value” is based on the “last” price). In practice, an investor might be able to buy the contracts for less than the ask price (i.e., some price between the bid and ask). Going by the ask price though, the cost of hedging against a greater-than-25% drop in FDN is pretty high: 6.72% of the position value. The cost of a similar hedge on HHH is 2.25% of position value.

Buying puts on a basket of Internet stocks

The first candidate I thought for this basket was Open Table (NASDAQ:OPEN), based partly on something Howard Lindzon wrote about the company on his blog last fall:

Nobody liked OpenTable.com when they went public in 2009. It has only tripled in 2010. OpenTable.com has the distribution with the restaurateurs and the brand name with the consumer. It took 10 plus years to get there. With $80 million in sales and $1.5 billion in market cap most smart people I know think it’s overvalued. That was 30 points ago. OpenTable.com will buy any talent and feature it needs. It is a much smarter way to own these fancy new start-ups and that is what the big money is doing. These momentum spurts can last much longer than you think. They are not that complicated. It helps to understand what’s happening in the start-up world at any given time and that’s why I love the intersection where I sit.

The “intersection” Lindzon referred to to there is between his roles as an investor in publicly traded companies, and as an entrepreneur and angel investor in start-ups. Other candidates I thought of were Amazon.com (AMZN), Netflix (NASDAQ:NFLX), Salesforce.com (NYSE:CRM), and Internet infrastructure plays Akamai Technologies (NASDAQ:AKAM) and Juniper Networks (NYSE:JNPR). Of those, AMZN, OPEN, and CRM had the highest valuations on a PEG basis, ranging from 2.01 for AMZN to 3.08 for CRM. Portfolio Armor presented these as the optimal put option contracts to hedge against greater-than-25% declines in these stocks:

The cost of hedging against greater-than-25% drops in these stocks was, respectively, 3.17% of position value for AMZN, 4.79% for CRM, and a lofty 11.56% for OPEN — an average cost of 6.5% of position value for the basket.

Hedging in this manner with the stocks or ETFs above isn't cheap right now. All else equal though, it would, of course, be cheaper to hedge with the same stocks and ETFs if you used a higher threshold for declines, e.g., hedging against a greater-than-30% decline instead of a greater-than-25% decline.

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