Adding Downside Protection To Facebook

| About: Facebook (FB)


In a recent article, Seeking Alpha contributor Brandon Dempster mentioned a way of hedging Facebook with inverse ETFs. In this article, we look at hedging Facebook with options.

We discuss two reasons we prefer options for hedging the stock, and show three ways of hedging Facebook: one with an optimal put, two with optimal collars.

We discuss why we believe a collar should be capped at a plausible estimate of the stock's potential return, and show the tradeoff involved with using a more optimistic estimate.

Protecting Your Facebook Investment

In Protecting Your Facebook Investment, Seeking Alpha contributor Brandon Dempster mentioned a way of hedging shares of Facebook (NASDAQ:FB) by buying inverse ETFs, such as the Direxion 3x Bear S&P 500 (NYSEARCA:SPXS) or the ProShares S&P 500 (NYSEARCA:SH). Although our hedged portfolio method sometimes includes levered inverse ETFs (here is a recent example), we generally prefer options over inverse ETFs for hedging. Reasonable individuals can disagree on this, as there are different tradeoffs involved, but we'll offer two reasons why we prefer options for hedging. Then we'll show a few ways of hedging Facebook with options. If you feel you may be a little rusty on options terms, you may want to click over to our previous article on hedging Realty Income (NYSE:O), and read the section titled, "Refresher on Hedging Terms."

Why We Prefer Options For Hedging

One reason we prefer options for hedging is that often a small dollar amount allocated to them can protect a much larger position or portfolio. This is due to the nonlinear way options react to movements in their underlying securities. A comparison of how the levered inverse ETF SH and a particular put option on the SPDR S&P 500 ETF (NYSEARCA:SPY) reacted to a market drop last summer illustrates the effect of that nonlinearity. As we mentioned in a previous article (How To Limit Your Market Risk), when the S&P 500 dropped 4% on August 24th, SH rose 13%. An optimal put option we had shared a few days earlier as a way of hedging market risk was up nearly 80% on the day.

That sort of nonlinearity enables you to get protection while allocating less money to options. And, all else equal, the less money you need to allocate to a hedge the better, because hedges can be a drag on your returns if whatever your hedging goes up in value.

Another reason we prefer options for hedging is that options on an individual stock can protect you against risk specific to that stock (idiosyncratic risk), whereas inverse ETFs will only protect you against broader market or sector risk (depending on what benchmark they target). In the case of Facebook, Dempster's focus on market risk makes some sense, as the most likely scenario in which Facebook shares might drop significantly in the near-term would be if the market as a whole dropped significantly. But if some event specific to Facebook knocked the stock down - say, an unexpectedly bad earnings release - then an inverse ETF might not provide as much of a hedge.

With that in mind, let's look at a few different ways of hedging Facebook with options, first with optimal puts.

Hedging FB With Optimal Puts

We're going to use Portfolio Armor's iOS app to find optimal puts and an optimal collar to hedge FB below, but you don't need the app to do this. You can find optimal puts and collars yourself by using the process we outlined in this article if you're willing to take the time and do the work. Whether you run the calculations yourself using the process we outlined or use the app, an additional piece of information you'll need to supply (along with the number of shares you're looking to hedge) when scanning for an optimal put is your "threshold", which refers to the maximum decline you are willing to risk. This will vary depending on your risk tolerance. For the purpose of the examples below, we've used a threshold of 19%. If you are more risk-averse, you could use a smaller threshold. And if you are less risk-averse, you could use a larger one. All else equal, though, the higher the threshold, the cheaper it will be to hedge.

Here are the optimal puts as of Monday's close to hedge 200 shares of FB against a greater-than-19% drop by mid-September.

As you can see at the bottom of the screen capture above, the cost of this protection was $1,070, or 4.99% of position value. A couple of points about this cost:

  1. To be conservative, the cost was based on the ask price of the put. In practice, you can often buy puts for less (at some price between the bid and ask).
  2. The 19% threshold includes this cost, i.e., in the worst-case scenario, your FB position would be down 14.01%, not including the hedging cost.

Hedging FB With An Optimal Collar

When scanning for an optimal collar, you'll need one more figure in addition to your threshold, your "cap", which refers to the maximum upside you are willing to limit yourself to if the underlying security appreciates significantly. One starting point for the cap is your estimate of how the security will perform over the time period of the hedge. For example, if you're hedging over a seven-month period, and you think a security won't appreciate more than 8% over that time frame, then it might make sense to use 8% as a cap; you don't think the security is going to do better than that anyway, so you're willing to sell someone else the right to call it away if it does better than that.

We checked Portfolio Armor's website to get an estimate of FB's potential return over the next several months. Every trading day, the site runs two screens to avoid bad investments on every hedgeable security in the U.S., and then ranks the ones that pass by their potential return. Potential return, in its terminology, is a bullish estimate. Unlike its fellow tech stocks Apple (NASDAQ:AAPL) and IBM (NYSE:IBM) recently, Facebook passed those two screens, and the site calculated a potential return for it of 16% over the next six months. This is 3 percentage points higher than the six-month potential return implied by the median (12-month) Wall Street price target show below (via Yahoo! Finance).

As you can see above, the median 12-month price target there was $135, which represented a 26% increase over Monday's closing price of $107.16 on Facebook, implying a 13% potential return over half that time.

As of Monday's close, this was the optimal collar to hedge 200 shares of FB against a greater-than-19% drop by mid-September, while not capping an investor's upside at less than 16%.

As you can see in the first part of the optimal collar above, the cost of the put leg was $820, or 3.83%, as a percentage of position value. But if you look at the second part of the collar below, you'll see the income generated by selling the call leg was slightly more, $830, or 3.87% of position value.

So the net cost of this optimal collar was negative, meaning an investor would have collected $10 more from selling the call leg than he paid for the puts, an amount equal to 0.05% of his position value. One note on this collar hedge:

  1. Similar to the situation with the optimal put, to be conservative, the cost of the optimal collar was calculated using the ask price of the puts and the bid price of the calls; in practice, an investor can often buy puts for less and sell calls for more (again, at some price between the bid and the ask). So, in reality, an investor would likely have collected more than $10 when opening this collar.

Hedging FB With Another Optimal Collar

Often when we post an optimal collar such as the one above, where the cap is smaller than the threshold, we get a comment from a reader saying that they'd rather have a higher possible upside than downside. The collar below is for those readers, to illustrate the tradeoff involved.

Below is the optimal collar, as of Monday's close, to hedge 200 shares of Facebook against a >19% drop by mid-September, while not capping an investor's upside at less than 38%.

As you can see above, the app has had to go back to the same strike puts it used in our first optimal put hedge, the cost of which is $1,070, or 4.99% as a percent of position value. And as you can see the below, the income generated from the call leg in this collar was $136, or 0.63% of position value.

So the net cost of this collar was $934, or 4.36% of position value. The same note about the hedging cost being calculated conservatively for the first two hedges applies to this one too, so, in practice, an investor could likely have opened this collar for less than $934. Say, for this example's sake, he could have opened it for $900. That would be his tradeoff for setting such an optimistic upside cap of 38% on this collar. Is it worth paying an extra $900, in this case, so that your cap is 2x your threshold? That's up to you, but our view is that you're better off letting your risk tolerance determine your threshold, and letting a plausible estimate of the stock's potential return over the time frame of your hedge determine your cap.

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

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

About this article:

Author payment: $35 + $0.01/page view. Authors of PRO articles receive a minimum guaranteed payment of $150-500.
Want to share your opinion on this article? Add a comment.
Disagree with this article? .
To report a factual error in this article, click here