JP Morgan: Priced For Perfection?

| About: JPMorgan Chase (JPM)
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With JP Morgan shares up about 30% from their February lows, analysts on Seeking Alpha and Estimize are upbeat about this week's earnings release.

Seeking Alpha contributor Josh Arnold suggests investors exit the stock though, in light of its current valuation.

For shareholders who want to stay long but limit their risk over the next several months, we present a couple of ways to hedge.

Screen capture via JP Morgan

JPM: Priced For Perfection?

Estimize, the crowd-sourced research platform, is bullish on JP Morgan's (NYSE:JPM) upcoming earnings, with its 899 JPM analysts estimating EPS of $1.41 per share, versus Wall Street's consensus of $1.38.

Screen capture via Estimize.

Seeking Alpha contributor Josh Arnold is also bullish on this week's JPM earnings, but suggests JP Morgan longs ring the register ahead of the release, given the stock's valuation and with it trading near its 52-week high. The stock is up nearly 30% from its February low.

Screen capture via JPM.

If you'd rather stay long JPM but limit your risk, we'll look at a couple of 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 JPM With Optimal Puts

We used Portfolio Armor's iOS app to find optimal puts and an optimal collar to hedge JPM, 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. Either way, you'll need to determine your "threshold," which is 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 Monday's close to hedge 1,000 shares of JPM against a greater-than-15% drop by mid-March.

As you can see at the bottom of the screen capture above, the cost of this protection was $1,350 or 13.03% of position value. A few points about this hedge:

  1. To be conservative, the cost was based on the ask price of the puts. In practice, you can often buy puts for less (at some price between the bid and ask).
  2. The 15% threshold includes this cost, i.e., in the worst-case scenario, your JPM position would be down 13.03%, 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 in the near term, when the puts may still have significant time value.

Hedging JPM With An Optimal Collar

When scanning for an optimal collar, you'll need one more numbering 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. 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.

The potential return over the next 5 months implied by the consensus 12-month Wall Street price target for JP Morgan is about 1% (we used data from Nasdaq below).

Screen capture via Nasdaq.

Portfolio Armor's website had a higher potential return for stock, about 9%, so we used that. Bear in mind, though, that, historically, actual returns have averaged about 0.3x the site's calculated potential returns.

This was the optimal collar, as of Monday's close, to hedge 1,000 shares of JPM against a >15% drop by mid-March, while not capping an investor's upside at less than 9% by then.

As you can see in the first part of the collar above, the app selected the same strike for the put leg of the optimal collar; that's not always the case, as we saw with United Technologies (NYSE:UTX) in our previous post. So the cost of the put leg was the same as above: $1,350, or 1.97% of position value. But as you can see in the second part of the collar below, the income generated from the call leg was $910, or 1.33% of position value.

So the net cost of this collar was $440 or 0.64% of position value. A couple of points 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 $440 when opening this collar.
  • This hedge may provide more protection than promised if JPM declines in the near future due to time value (for an example of this, see this article on hedging Apple (NASDAQ:AAPL)). However, if JPM 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 (NASDAQ:FB) -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.