Hedging 5 Stocks That Were Upgraded On Thursday

by: David Pinsen

5 Stocks Upgraded To "Buy" or "Strong Buy"

On Thursday, four names were upgraded to "buy" by at least one analyst, and one, ViroPharma (VPHM), was upgraded to "strong buy". The table below shows the costs of hedging them against greater than 26% declines over the next several months, using optimal puts.

A Comparison

For comparison purposes, I've also included the costs of hedging the SPDR Dow Jones Industrial Average ETF (NYSEARCA:DIA) against the same decline. First, a reminder about what optimal puts are, and a note about why I've used 26% as a decline threshold here; then, a screen capture showing the current optimal puts to hedge one of these stocks, Leap Wireless (LEAP).

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.

Decline Thresholds

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% decline threshold when hedging equities, but the cost of hedging Leap Wireless against a 20% decline was itself greater than 20% of position value, so Portfolio Armor indicated there were no optimal puts for that. The lowest decline threshold against which it was possible to hedge LEAP was 26%, so that's the threshold I've used below.

The Optimal Puts For LEAP

Below is a screen capture showing the optimal put option contract to buy to hedge 100 shares of LEAP against a greater-than-26% drop between now and July 20th, 2012. A note about these optimal put options and their cost: to be conservative, Portfolio Armor 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. Still, the hedging costs for LEAP are extremely expensive. Recall a previous article ("High Optimal Hedging Costs: A Red Flag?") where we speculated that high hedging costs could presage future underperformace.

Hedging Costs as of Thursday's Close

The hedging data in the table below is as of Thursday's close, and is presented as a percentage of position value. The name of the firm that employs the analyst who upgraded each company to is listed to the right of the upgraded company's name.



Analyst's Firm

Hedging Cost

LRCX Lam Research Corp Needham 5.67%**
LEAP Leap Wireless Mizuho 23.9%***
PCS Metro PCS Mizuho 8.29%*
NYB New York Community Standpoint Research 5.42%***
VPHM ViroPharma WBB Securities 5.40%*

*Based on optimal puts expiring in May 2012.

**Based on optimal puts expiring in June 2012.

***Based on optimal puts expiring in July 2012.

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

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