Square: Crash Protection Kicks In

About: Square, Inc. (SQ)
by: David Pinsen


Last month, I presented two ways of hedging Square, in light of its large run-up and concerns raised about its valuation. Since then, the stock is down 20%.

Here, I show how the two September hedges have ameliorated the decline.

I also briefly discuss possible courses of action from here for hedged Square longs.

The Doughnut Project

Square-using doughnut shop The Doughnut Project (via Square's Instagram).

Square On A Tear

Shares of Twitter (TWTR) CEO Jack Dorsey's other company, Square (SQ), went on a tear after I shared it as a Portfolio Armor top 10 name with Bulletproof Investing subscribers on February 8th. Over the next 6 months, SQ was up nearly 80%, as the chart below, via Portfolio Armor, shows.

Last month though, I noted a warning about Square's valuation, and presented two ways longs could hedge (Crash Protection For Square). Here, I show how those hedges reacted to the stock's drop since.

Crash Protection Kicks In For Square

Since I shared those Square hedges, the stock has dropped more than 20%.

Chart SQ data by YCharts

Let's look at how the hedges ameliorated that slide and briefly discuss courses of action for hedged Square longs now.

The September Optimal Put Hedge

On September 18th, these were the optimal, or least expensive, puts to hedge Square against a greater-than-18% drop by mid-March (screen capture via the Portfolio Armor iPhone app).

Image via PA.

Note that the cost was a bit high: $7,250, or 8.24% of position value (calculated conservatively, using the ask price of the puts).

Let's look at how that hedge has reacted to the 20% drop.

How The Optimal Put Hedge Has Reacted

Here's an updated quote on those puts as of Thursday's close (via CBOE):

How That Hedge Ameliorated Square's Drop

SQ closed at $87.89 on September 18th. A shareholder who owned 1,000 shares of it and hedged with the puts above then had $87,890 in SQ shares plus $7,250 in puts, so the net position value was $87,890 + $7,250 = $95,140.

SQ closed at $69.03 on Thursday, October 11th, down more than 20% from its close on September 18th. The investor's shares were worth $69,030 on Thursday, and the put options were worth $16,225, using the midpoint of the spread. So, the net position value as of Thursday's close was $69,030 + $16,225 = $85,255. $85,255 represents a 10.4% drop from $95,140.

The September Optimal Collar Hedge

On September 18th, this was the optimal collar to protect against a >18% drop in SQ by mid-March, while not capping your possible upside at less than 19% by then.Image via PA.

In this case, the net cost of the hedge was negative, meaning you would have collected a $2,250 net credit, assuming, conservatively, that you bought the puts and sold the calls at the worst ends of their respective spreads.

How That Optimal Collar Hedge Has Reacted

Here's an update quote on the put leg of the collar (note that it's at a different strike than the first hedge):

And here's an updated quote on the call leg:

How That Hedge Ameliorated Square's Drop

Recall that SQ closed at $87.89 on September 18th. A shareholder who owned 1,000 shares of it and hedged with the collar above then had $87,890 in SQ shares, $3,800 in puts, and if the investor wanted to buy-to-close the short call position, it would have cost him $6,050. So, the net position value on September 18th was ($87,890 + $3,800) - $6,050 = $85,640.

Since SQ closed at $69.03 on Thursday, October 11th, the investor's shares were worth $69,030, the put options were worth $9,700, and it would have cost $1,815 to buy-to-close his calls, using the midpoint of the spread in both cases. So: ($69,030 + $9,700) - $1,815 = $76,915. $76,915 represents a 10.2% drop from $85,640.

More Protection Than Promised In Both Cases

Although Square had dropped by about 20% from September 18th to October 11th, and both hedges were designed to protect against a >18% drop, the optimal put hedged position was only down 10.4%, and the optimal collar hedged position was down 10.2%. In both cases, the time value of the put options gave a bit more protection than promised since the hedges were structured to protect based on intrinsic value alone.

What Now?

That's up to you, but the nice thing about being hedged is that it gives you options (no pun intended). You don't have to worry so much about how much further Square might drop, because your downside is strictly limited. You can exit now, for a smaller loss; you can buy-to-close the call leg of your collar to remove your upside cap, if you're bullish; and if you're even more bullish, you can sell your appreciated puts and buy more Square shares. In any case, you have breathing space to let the dust settle and decide on your best course of action, without the anxiety of an unhedged investor.

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.