Tell Me Something I Don't Know
You know Apple's (NASDAQ:AAPL) earnings were a disappointment across the board, as Seeking Alpha contributor Seth Golden put it. What you may not know is, the day after Apple's earnings release, dark pool short interest in the stock shot up. We didn't know either, until we got an alert from SqueezeMetrics after the close Wednesday.
Readers of our previous article on Citigroup (NYSE:C) (Dark Citi) 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 earlier this year, "Seeking Alpha In The Dark."
According to SqueezeMetrics, dark pool shorting volume in Apple (the red areas in the chart below) spiked 3.1x on Wednesday, suggesting some institutional investors had soured on the stock post-earnings.
Social Data Trumps Crowd-Sourced Earnings Estimate
In an article published last Friday (Hedging Apple Ahead Of Earnings), we noted that while Estimize's crowd-sourced analysts were more bullish on Apple's earnings than Wall Street, LikeFolio had put out a sell rating on the stock based on their analysis of social media data. As co-founder Andy Swan summarized it on their site,
Everything just eroding slowly. Low consumer enthusiasm and confusion around product lines.
In response to a reader's request for elaboration, we contacted Swan via Twitter (NYSE:TWTR) after our article was published, and he added some color:
When we plot "purchase intent mentions" for Apple on a 30 day moving average, we see a steady erosion over the past 4-6 months. We also have seen FAR lower purchase intent mentions surrounding Apple's new product releases than prior (even comparably minor) product releases.
In light of LikeFolio's bearish analysis being buttressed by Apple's weak earnings, and the spike in dark pool short interest, hedged Apple longs may want to reconsider their positions. We'll look at the status of their hedges below and consider possible courses of action.
Status Of Last Week's Optimal Put Hedge
These were the optimal puts to hedge against a greater-than-14% drop in Apple shares over the next six months, as of last Thursday's close (the screen capture below is from the Portfolio Armor iOS app).
Although this hedge was only designed to protect against a >14% decline, as we noted last week,
[It] 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.
That turned out to be the case, as we'll see below.
Here's an updated quote on that put, as of Wednesday's close.
How that hedge ameliorated Apple's decline
AAPL closed at $105.97 on Thursday, April 21st. A shareholder who owned 600 shares of it and hedged with the puts above had $63,582 in AAPL stock plus $2,070 in puts then, so his combined hedged position value was $63,582 + 2,070 = $65,652.
AAPL closed at $97.82 on Wednesday, April 27th, down 7.7% from its closing price on April 21st. The investor's shares were worth $58,692 as of 4/27, and his put options were worth $3,360, so: $58,692 + $3,360 = $62,052. $62,052 represents a 5.5% drop from $65,652.
More Protection Than Promised
So, although AAPL had dropped by 7.7% at the time of the calculations above, and the investor's hedge was designed to limit him to a loss of no more than 14%, he was actually down only 5.5% on his combined hedge + underlying stock position by this point.
Status Of Last Week's Optimal Collar Hedge:
As of last 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% by the end of that time period.
We included a similar note about time value with this hedge:
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
And that turned out to be the case with this hedge as well, as we'll see below.
How The April 21st Collar Responded To Wednesday's Drop
Here's an updated quote on the put leg as of Wednesday's close:
And here is an updated quote on the call leg:
How That Hedge Ameliorated Apple's Drop
AAPL closed at $105.97 on Thursday, April 21st. A shareholder who owned 600 shares of it and hedged with the collar above then had $63,582 in AAPL stock plus $1,698 in puts, and if he wanted to buy-to-close his short call position, he would have needed to pay $2,040 to do that. So, his net position value on April 21st was ($63,582 + $1,698) - $2,040 = $63,240.
AAPL closed at $97.82 on Wednesday, April 27th, down 7.7% from its closing price on April 21st. The investor's shares were worth $58,692 as of 4/27, his put options were worth $2,760 and if he wanted to close out the short call leg of his collar, it would have cost him $792. So: ($58,692 + $2,760) - $792 = $60,660. $60,660 represents a 4% drop from $63,240.
More Protection Than Promised
So, although AAPL had dropped by 7.7% at the time of the calculations above, and the investor's hedge was designed to limit him to a loss of no more than 14%, he was actually down only 4% on his combined net hedge + underlying stock position by this point.
Courses Of Action For Hedged Apple Shareholders
Being hedged gives an investor breathing room to decide what his best course of action is. The courses of action are a bit simpler for the investor hedged with puts. He can exit his position (stock and put options) now for a 5.5% loss (instead of a 7.7% one); he can wait to see what happens; or, if he is bullish on Apple and doesn't think it's going to drop any more, he can sell his appreciated puts and use the proceeds to buy more shares.
An Apple investor hedged with the collar could exit his position with an 4% loss now (instead of a 7.7% one), he could wait to see what happens, or if he remains a long term bull, he could buy-to-close the call leg of this collar, to eliminate his upside cap. If he's even more bullish, after eliminating his upside cap, he could sell his appreciated puts, and use those proceeds to buy more stock.
When backtesting the hedged portfolio method, we tested variations of the first two of those four scenarios, although we limited our tests to situations where the underying security dropped below the threshold it was hedged against (that hasn't happened here with Apple yet). We looked at whether, on average, hedged portfolio performance was better if those losing positions were exited 3 months into the duration of the portfolio, or held for 6 months, or until just before their hedges expired, whichever came first. We found that, on average, investors were better off holding their losing positions for six months or until just before their hedges expired, whichever came first.
Tradeoff: Time Value Versus Time For Recovery
The tradeoff involved there is this: the longer you hold the position, the more time the price of the underlying security has to recover; on the other hand, the sooner you exit the position, the more time value your put options have. If you think Apple is likely to drift lower in light of the negative social data and the spike in dark pool shorting, you may want to exit for a mid single-digit loss now.
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.