Citi Flat After Earnings, But Dark Pool Short Interest Spikes
The market's reaction to Citigroup's (NYSE:C) earnings release on Friday was a bit anticlimactic. As Seeking Alpha contributor John M. Mason summarized it, Citi's bad quarter (27% year-over-year drop in profits and 11% drop in revenues) beat Wall Street's subdued expectations, but the jury is still out on CEO Michael Corbat's turnaround plan. After the stock closed down fractionally on the day, it was still up over 28% from its February low.
Although the market's reaction to Citi's earnings was muted, dark pool short interest in the stock spiked after earnings.
Readers of our previous article on Facebook (NASDAQ:FB) ("Facebook: Proceed With Caution") will be familiar with dark pools, but for those unfamiliar with the term, these are private exchanges where institutions trade shares without the transparency of public markets. That 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".
According to SqueezeMetrics, dark pool shorting volume (the red areas in the chart below) spiked 3.3x after Citi's earnings on Friday, suggesting institutional investors were less sanguine about the company's prospects than the market overall.
Hedging Your Bets On Citi
If you're long Citi and are still bullish on it, but you want to limit your downside risk in light of the spike in dark pool shorting and the uncertainty John Mason mentioned, 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 our previous article on hedging Realty Income (NYSE:O).
Hedging C With Optimal Puts
We'll use Portfolio Armor's iOS app to find optimal puts and an optimal collar to hedge C below, but you don't need the app for this. You can find optimal puts and collars yourself by using the process we outlined in this article if you're willing to do the math. Whether you run the numbers 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 15%. 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 Friday's close, to hedge 400 shares of C against a greater-than-15% drop by mid-September:
As you can see at the bottom of the screen capture above, the cost of this protection was $548, or 3.05% of position value. Two 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 15% threshold includes this cost, i.e., in the worst-case scenario, your C position would be down 11.95%, not including the hedging cost.
Hedging C 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 5% over that time frame, then it might make sense to use 5% 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 C'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. Unlike Facebook last time, Citigroup didn't pass those two screens, so the site didn't calculate a potential return for it. So, we looked 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 $55, which represented a 22% increase over Friday's closing price of $44.92, implying a 9.3% potential return over the next five months. So, we started out using 9.3% as a cap, but when we were able to raise it to 11% without raising the cost of the collar, we used that.
As of Wednesday's close, this was the optimal collar to hedge 400 shares of C against a greater-than-15% drop by mid-September, while not capping an investor's upside at less than 11%:
As you can see in the first part of the optimal collar above, the app used the same strike for the put leg as in the optimal put hedge above, so the cost was the same: $548, or 3.05%. But if you look at the second part of the collar below, you'll see the income generated by selling the call leg was $376, or 2.09% of position value:
So, the net cost of this optimal collar was $172, or 0.96% of position value.
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 paid less than $172 when opening this collar.
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.