Who's Shorting Microsoft?
Microsoft (NASDAQ:MSFT) cofounder and current technology advisor Bill Gates had a lot to smile about back in 1995. Those were Microsoft's glory days, and its stock gained 43% that year. He had reason to smile this week too, as Microsoft presented its Q4 results. CNBC's Jim Cramer was happy with them.
And as Seeking Alpha news editor Eric McCaffrey reported, analysts from Nomura Securities, BMO Capital Markets, and FBN Securities were happy with the release too, all raising their price targets on the stock, and restating their "buy" or "outperform" ratings on it.
Given the positive reaction by analysts and by the market on Wednesday, we were suprised to receive this automated email from SqueezeMetrics after the close:
Looks like there was some unusual dark pool activity in some of the tickers you follow.
MSFT had 3.6x 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 earlier this year, Seeking Alpha In The Dark.
After seeing that email from SqueezeMetrics, we 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 July 20th.
Adding Downside Protection To Microsoft
If you're long Microsoft and are still generally bullish on it, but you want to limit your downside risk in light of the spike in short interest, 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 MSFT With Optimal Puts
We'll 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 for that. 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 less risk-averse, you could use a larger one. All else equal, the higher the threshold, the cheaper it will be to hedge.
Here are the optimal puts, as of Wednesday's close, to hedge 500 shares of MSFT against a greater-than-16% drop by late January.
As you can see at the bottom of the screen capture above, the cost of this protection was $510 or 1.82% 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 MSFT position would be down 14.18%, not including the hedging cost.
- The threshold is based on the intrinsic value of the puts, so they may provide more protection than promised if the underlying security declines in the near term, when the puts may still have significant time value.
Hedging MSFT With An Optimal Collar
When scanning for an optimal collar, you'll need another 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. One starting point for the cap is your estimate of how the security will perform over the time period of the hedge -- 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 MSFT'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. Microsoft passed, and the site estimated a potential return of 6.3% for it over 6 months. That was higher than the 6-month potential return implied by the Wall Street consensus 12-month price target for the stock (screen captured via NASDAQ below).
So, we started with a cap of 6.3%, and when we were able to raise that to 7% without raising the hedging cost, we used 7%.
As of Wednesday's close, this was the optimal collar to hedge 500 shares of MSFT against a greater-than-16% drop by late January, while not capping an investor's upside at less than 7% by then.
As you can see in the first part of the optimal collar above, the put leg is the same as in the optimal puts above, so the cost is the same: $510 or 1.82% 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 $605, or 2.16% of position value.
So the net cost of this optimal collar was negative, meaning an investor opening it would collect an amount equal to $160, or 0.57% of position value. A couple of 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 $160 when opening this collar.
- This hedge may provide more protection than promised if the underlying security declines in the near future due to time value (for an example of this, see this recent article on hedging Apple). However, if the underlying security spikes in the near future, time value can have the opposite effect, making it costly to exit the position early (for an example of this, see this article on hedging Facebook - Facebook Rewards Cautious Investors Less).
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.