- On Wednesday there were two potentially bearish indicators for Facebook. The first, noted by Karl Eggerss, was a potential double top in the stock.
- The second, noted by SqueezeMetrics, was a 3.4x spike in the volume of dark pool shorting of Facebook shares.
- We elaborate on both indicators and present two ways for Facebook longs to add downside protection.
Two Reasons For Facebook Longs To Be Cautious
The first reason for Facebook (FB) longs to be cautious is the candlestick chart above, shared via StockTwits by Karl Eggerss of Eggerss Capital Management. As Eggerss suggests, this chart could be the beginning of a bearish technical formation known as a Double Top Reversal.
Perhaps not coincidentally, shortly after seeing Eggerss' chart on Wednesday, we received the automated email below from SqueezeMetrics:
Looks like there was some unusual dark pool activity in some of the tickers you follow.
FB had 3.4x more dark pool shorting than usual.
Dark pools, for readers who may be unfamiliar with the term, are private exchanges where institutions trade shares without the transparency of public markets. This enables them to place large block trades away from front-runners and other predatory traders on public exchanges. Seeking Alpha contributor SqueezeMetrics elaborated on how dark pools work, and why investors should pay attention to them, in an article a couple of months ago, Seeking Alpha In The Dark.
After seeing that email from SqueezeMetrics, I signed on to their site and pulled up the chart below. The red part of the histogram represents the volume of dark pool shorting, and you can see how that spiked on April 13th.
Adding Downside Protection To Facebook
If you're long Facebook and are still generally bullish on it, but you want to limit your downside risk in light of the reasons mentioned above, we'll look at two ways of hedging it over the next several months below. If you'd like a refresher on hedging terms first, please see the section titled "Refresher On Hedging Terms" in this previous article of ours, Locking In Gold Gains.
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 16%. 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 Wednesday's close, to hedge 300 shares of FB against a greater-than-16% drop by mid-September.
As you can see at the bottom of the screen capture above, the cost of this protection was $1,350, or 4.07% of position value. A couple of points about this cost:
- 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).
- The 16% threshold includes this cost, i.e., in the worst-case scenario, your FB position would be down 11.93%, 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 five-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. Facebook passed those two screens, and the site calculated a potential return for it of 10% over the next six months, which equates to about 8.3% over the time frame of our hedge. This is pretty close to the return implied by the median (12-month) Wall Street price target shown below (via Yahoo Finance).
As you can see above, the median 12-month price target there was $135, which represented a 22% increase over Wednesday's closing price of $110.51, implying a 9.2% potential return over the next five months. So, we started out using 9.2% as a cap, but when we were able to raise it to 13% without raising the cost of the collar, we used that.
As of Wednesday's close, this was the optimal collar to hedge 300 shares of FB against a greater-than-16% drop by mid-September, while not capping an investor's upside at less than 13%.
As you can see in the first part of the optimal collar above, the cost of the put leg was $975, or 2.94% 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 a bit more, $1,125, or 3.39% of position value.
So the net cost of this optimal collar was negative, meaning an investor would have collected $150 more from selling the call leg than he paid for the puts, an amount equal to 0.45% of his position value. One note on this collar hedge:
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 $150 when opening this collar.
This article was written by
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