O No?

| About: Realty Income (O)

Summary

Realty Income, popular for its monthly dividend payments, has been a top-performing REIT, but, increasingly, analysts have become concerned about its valuation.

As an example, in a recent article, Seeking Alpha contributor Bret Kenwell disclosed that he'd sold the stock and predicted it could pullback as much as 20%.

We look at two ways of limiting Realty Income's downside risk over the next several months and discuss which approach is worth considering for risk-averse Realty Income longs.

Realty Income Still Pricey As A Former Long Sells

Last time we looked at hedging Realty Income (NYSE:O), in late February, we wrote that the REIT was pricey but it passed the two screens our site uses to eliminate some potentially bad investments. Since then, shares of Realty Income have been essentially flat, as the chart below shows.

On Monday, a day before Realty Income's scheduled earnings release, Seeking Alpha contributor Bret Kenwell explained why he decided to exit the stock (I Sold O). In short, while he still considers it to be a great company, he feels the stock's valuation has gotten stretched too far (Wall Street analysts tend to agree; more on that below). Kenwell says O could fall as much as 20%.

If you are long O, concerned by Kenwell's warning, and can't tolerate a decline of 20%, you ought to consider taking steps to limit your risk. The simplest of those steps would be to do what Kenwell has done and sell your shares. Another approach is to stay long and hedge. We'll look at two ways of doing that below, but if you'd like a refresher on hedging terms first, see the section titled, "Refresher On Hedging Terms" in our previous article on hedging Apple (NASDAQ:AAPL), Hedging Apple Ahead Of Earnings.

Hedging O With Optimal Puts

We're going to use Portfolio Armor's iOS app to find optimal puts and an optimal collar to hedge O 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 do the math. Whether you run the calculations yourself using the process we outlined or use the app, one 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 12%. 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 O against a greater-than-12% drop by mid-September.

As you can see at the bottom of the screen capture above, the cost of this protection was $620, or 2.57% of position value. The cost there is why we suspect most O shareholders wouldn't be interested in this hedge: on an annualized basis, it's significantly higher than the REIT's yield, and the yield is part of what attracted you to the "monthly dividend company", as the image from Realty Income's website below describes it.

Nevertheless, let's note a few points about this hedge:

  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 12% threshold includes this cost, i.e., in the worst-case scenario, your O position would be down 9.43%, 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 O With An Optimal Collar

When looking 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 several-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.

As we mentioned above, Bret Kenwell's assessment about O's valuation is supported by Wall Street analysts, as the screen capture below from Yahoo Finance shows.

Ordinarily, we'd consider using a cap based on the median price target, but the median price target shown above was $57, which was lower than O's closing price on Monday, $60.32. So, instead, we used the high target of $70, which implies a potential return of 7% between now and mid-September.

As of Monday's close, this was the optimal collar to hedge 400 shares of O against a greater-than-12% drop by mid-September, while not capping an investor's upside by less than 7% at the end of that time frame.

As you can see in the first part of the optimal collar above, the put leg was the same strike as the optimal puts above, so the cost was the same: $620, or 2.57% 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 about half that.

So, the net cost of this optimal collar was $320, or 1.33% of position value.

Two notes about 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 paid less than $320 when opening this collar.
  • 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.

Does It Make Sense To Hedge Or Hold O?

This depends on your risk tolerance and your sensitivity to hedging cost. If you can't tolerate a drawdown of more than 12%, then it doesn't make sense risking a drawdown larger than that by holding the stock unhedged. And if the cost of hedging it is too high for you, then you may want to consider following Bret Kenwell's example and exiting your position. Bear in mind, though, that if you are willing to risk a larger drawdown than 12%, you may be able to reduce or eliminate the cost of hedging O with an optimal collar. That was the case in the collar shown in our February article, which used the same cap, but a threshold of 17% instead of 12%.

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.

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