Adding Downside Protection To Gilead Sciences

| About: Gilead Sciences, (GILD)
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In a recent article, Seeking Alpha contributor Shock Exchange raised two warnings about Gilead Sciences.

One of Shock Exchange's warnings concerned Gilead's royalties due Merck; another concerned the potential impact of global economic weakness on Gilead's sales.

For Gilead longs who remain bullish on the stock but are interested in limiting their downside risk, we present two ways of hedging the stock over the next several months.

Warning Flags For Gilead Longs

In an article on Monday (Avoid Gilead), Seeking Alpha contributor Shock Exchange raised two warning flags for Gilead Sciences (NASDAQ:GILD) longs and investors considering buying the stock. One of those warning flags concerned Gilead's royalties owed to Merck (NYSE:MRK), and the other related to the global economy and its potential impact on sales of Gilead's Hepatitis C treatment, which the image below, by Bidness Etc., alludes to (along with Gilead's Hepatitis treatment competitor AbbVie (NYSE:ABBV)).

On the royalty issue, Shock Exchange noted that the presiding judge has yet to determine the amount, and that this uncertainty could weigh on the company:

A judge will determine what ongoing royalties the company will have to pay going forward. The royalty amount creates another uncertainty for GILD, and has the potential to be more damaging financially.

On the impact of the global economy on sales of Gilead's Hepatitis treatment, Shock Exchange noted that Gilead faces pricing pressure in the first world as well as the developing world:

Of the 150 million HCV [Hepatitis C Virus] infecteds worldwide, the majority are in foreign countries. The discount for an HCV regimen in Egypt and other developing nations is over 90% off the list price. In developed countries in Europe, revenue-per-start is already trending much lower vis-a-vis the U.S. GILD bull Jim Kimmelman attributes the disparity in pricing to budget constraints and a lower GDP in Europe. It could worsen as the global economy is in shambles

Staying Long Gilead While Limiting Downside Risk

For Gilead Sciences shareholders who remain generally bullish on the stock, but want to limit their downside risk over the next several months in light of the concerns raised by Shock Exchange, we'll look at two ways of hedging Gilead below: one with optimal puts, and one with an optimal collar. If you'd like a refresher on those and other hedging terms first, please see the section titled "Refresher On Hedging Terms" in this article of ours from last month, Locking In Gold Gains.

Hedging GILD With Optimal Puts

We're going to use Portfolio Armor's iOS app to find optimal puts and an optimal collar to hedge GILD 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 math. 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 is 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 20%. 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 400 shares of GILD against a greater-than-20% drop by mid-August.

As you can see at the bottom of the screen capture above, the cost of this protection was $880, or 2.4% 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 20% threshold includes this cost, i.e., in the worst-case scenario, your GILD position would be down 17.6%, not including the hedging cost.

Hedging GILD 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 several-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 GILD'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. GILD passed those two screens on Monday, but the site only calculated a potential return for it of 2.75%. We assume that most GILD longs wouldn't hold the stock in light of current risks if they thought that its potential return was that low, so we won't use that potential return in our next hedge.

Instead, we'll use a potential return estimate derived from the median Wall Street price target for GILD, screen captured below, via Yahoo.

That median price target of $115 represents a 24.4% gain over $92.46, but that's a 12-month price target. It suggests a return of closer to 9% over the time frame of the hedge, so we'll use 9% as a cap in our hedge below.

This was the optimal collar, as of Monday's close, to hedge 400 shares of GILD against a >20% drop by mid-August, while not capping an investor's upside at less than 9%.

As you can see above, the app was able to use a less expensive, slightly more out-of-the-money put this time, the cost of which was $572, or 1.55% of position value. And as you can see the below, the income generated from the call leg in this collar was a bit higher, $668, or 1.81% of position value.

So the net cost of this collar was negative, and the investor would have collected an amount equal to $96, or 0.26% of position value when opening this hedge. The same note about the hedging cost being calculated conservatively for the first hedge applies to this one too, so, in practice, an investor could likely have collected more than $96 when opening this hedge.

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.