Hedging Apple Ahead Of Earnings

| About: Apple Inc. (AAPL)
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Crowd-sourced data paints a conflicting picture of Apple ahead of earnings. The thousands of analysts reporting to Estimize are, in aggregate, bullish on Tuesday's earnings.

On the other hand the social data analyzed by Likefolio shows an erosion in customer enthusiasm for Apple products, and a confusion about the company's offerings.

In light of the conflicting data, we present two ways for Apple longs to limit their downside risk.

Crowd-Sourced Data Conflicted On Apple

With Apple (NASDAQ:AAPL) reporting earnings next Tuesday (delayed a day due to a memorial for Silicon Valley icon and former Apple board member Bill Campbell), two startups that aggregate crowd-sourced data offer a conflicted picture of the company's prospects.

On the bullish side, the nearly 5,000 Apple analysts reporting to Estimize collectively predict the company will beat Wall Street's consensus earnings estimate next week, as the graph below shows.

The Estimize consensus earnings estimate shown above, $2.04, is 7 cents ahead of the Wall Street consensus of $1.97. Since its analysts include private investors as well as those from independent research shops, buy side firms, and sell side firms, Estimize says its estimates tend to be more accurate than those from Wall Street analysts alone.

On the bearish side, is social data analyzer Likefolio.

There's a lot of chatter on social media about individual stocks, but a challenge with generating useful data from it is the tendency of an investor to "talk his book" - anyone who is long a particular stock is likely to make bullish comments about it, and vice versa. Likefolio attempts to surmount this challenge by mining comments about brands owned by publicly traded companies, rather than the stocks themselves, as the image above from its website illustrates.

Someone who comments about Yum Brands (NYSE:YUM) on Facebook (NASDAQ:FB), Twitter (NYSE:TWTR) or other social media platforms may be talking his book. But for every YUM investor, there are many more Taco Bell, KFC, and Pizza Hut customers, and they are sharing their thoughts about those brands on social media constantly (to see an example for yourself, enter "Taco Bell" in the search field on Twitter now, and click the "Live" tab). A drop in social data sentiment and volume on Yum Brands offered a warning last June that was confirmed by the company's disappointing earnings release last October.

Likefolio posted a sell rating on Apple on Wednesday:

Everything just eroding slowly. Low consumer enthusiasm and confusion around product lines.

Limiting Downside Risk For Apple Longs

For Apple longs buoyed by the bullish Estimize earnings prediction, but concerned about the bearish trend suggested by Likefolio's analysis, we'll present a couple of ways of hedging the stock below. First, though, a quick refresher on hedging terms.

Refresher On Hedging Terms

Recall that puts (short for put options) are contracts that give an investor the right to sell a security for a specified price (the strike price) before a specified date (the expiration date). And calls (short for call options) are contracts that give an investor the right to buy a security for a specified price before a specified date. Optimal puts are the ones that will give you the level of protection you want at the lowest cost.

A collar is a type of hedge in which you buy a put option for protection, and at the same time, sell a call option, which gives another investor the right to buy the security from you at a higher strike price by the same expiration date. The proceeds from selling the call option can offset at least part of the cost of buying the put option. An optimal collar is a collar that will give you the level of protection you want at the lowest cost, while not capping your possible upside by more than you specify. In a nutshell, with a collar, you may be able to reduce the cost of hedging in return for giving up some possible upside.

Hedging Apple With Optimal Puts

We're going to use Portfolio Armor's iOS app to find an optimal put and an optimal collar to hedge AAPL 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 14%. 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 Thursday's close to hedge 600 shares of AAPL against a greater-than-14% drop by late October.

As you can see at the bottom of the screen capture above, the cost of this protection was $2,070, or 3.26% 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 14% threshold includes this cost, i.e., in the worst-case scenario, your AAPL position would be down 10.74%, not including the hedging cost.
  3. The threshold is based on the intrinsic value of the puts, so they may provide more protection than promised if the underlying security declines significantly in the near term, when the puts may still have significant time value.

Hedging AAPL With An Optimal Collar

When scanning for an optimal collar, you'll need one more number 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. A logical 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 6-month period, and you think a security won't appreciate more than 10% over that time frame, then it might make sense to use 10% 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 AAPL's potential return over the time frame of the hedge. Every trading day, the site runs 2 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 of how a security will perform over the next several months. Apple passed both screens and the site estimated a potential return of 4.6% for it. We also calculated a potential return for Apple using Wall Street brokers' median price target for the stock via Yahoo Finance (pictured below).

That median price target of $130 represented a 22% increase from Apple's Thursday closing price of $105.97, but those price targets go out 1 year, so that suggests a potential return of 11% over the next six months. We decided to split the difference between the two estimates and use a cap of 8%.

As of Thursday's close, this was the optimal collar to hedge 600 shares of AAPL against a greater-than-14% drop by late October, while not capping an investor's upside by less than 8%.

As you can see in the first part of the optimal collar above, the cost of the put leg was $1,698, or 2.67% 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 higher: $2,040, or 3.21% of position value.

So, the net cost was negative, meaning an investor opening this collar would have collected an amount equal to $342, or 0.54% of position value. Two notes on this hedge:

  • Similar to the situation with the optimal puts, 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 $342 when opening this collar.
  • Although the 14% threshold takes into account positive hedging cost (as we noted above), it doesn't take into account negative hedging cost. So, taking into account negative hedging cost of 0.54%, the worst-case scenario for Apple investor hedged with this collar would be a drawdown of 13.46%.
  • As with the optimal puts above, this hedge may provide more protection than promised if the underlying security plummets in the near future, due to the put leg's combination of intrinsic value and time value (for an example of this, see the section titled "More Protection Than Promised" in this article). However, if the underlying security spikes in the near future, the combined time value and intrinsic value of the call leg can have the opposite effect, making it costly to exit the position early.

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.