Firefighters searching a burned down building after one of last fall's wildfires (Photo via David Paul Morris/Bloomberg).
"One Fire Away From Ruin"
As PG&E Corp. plunged into bankruptcy last month, S&P Global Ratings slashed credit grades almost to junk status for California's two other big electric utilities, owned by Sempra Energy and Edison International, and said they could go lower.
The reason: Inverse condemnation. Under the state's view of this legal doctrine, utilities can be held liable for any fires sparked by their equipment, even if they follow every safety rule. With deadly blazes getting bigger and more common, California's two remaining big power companies could be just one fire away from ruin.
Bloomberg went on to note that the utilities were seeking a legislative remedy to the inverse condemnation issue. In the event they don't succeed and there's another disastrous fire over the next several months, below are ways Sempra and Edison International shareholders can limit their risk. As a reminder: You hedge when you are bullish but want to limit your risk if you end up being wrong. If you're no longer bullish in these utilities, you shouldn't own them.
Adding Downside Protection To Sempra Energy
For all of the examples below, I'm going to assume you have 500 shares of each utility and can tolerate a drawdown of 20% over the next several months, but not one larger than that. Screen captures for the hedges below are via the Portfolio Armor iPhone app.
Uncapped Upside, Positive Cost
As of Friday's close, these were the optimal puts to hedge 500 shares of SRE against a >20% decline by late July.
The cost of this protection was $275 or 0.47% of position value. That cost was calculated conservatively using the ask price of the puts. In practice, you can often buy and sell options at some price within the bid-ask spread.
Capped Upside, Negative Cost
If you were willing to cap your upside at 10% over the same time frame, this was the optimal collar to provide you with the same level of downside protection.
In this hedge, the put leg used the same strike as the previous hedge, so the cost of that was the same: $275 or 0.47% of position value. The income generated by selling the call leg, $400 or 0.68% of position value (calculated conservatively, at the bid), was more than enough to offset the cost of the put leg though.
So, the net cost of this collar was negative, meaning you would have collected a net credit of $125, assuming you placed both trades at the worst ends of their respective spreads.
Adding Downside Protection To Edison International
Uncapped Upside, Positive Cost
These were the optimal puts, as of Friday's close, to hedge 500 shares of EIX against a >20% decline by late July.
The cost of this put protection on EIX was $925 or 3.19% of position value, calculated at the ask.
Uncapped Upside, Negative Cost
If you were willing to cap your possible upside at 7%, this was the optimal collar to give you the same level of downside protection over the same time frame.
One difference between this EIX optimal collar and the optimal collar for SRE is that, in this case, after an iterative process taking into account the net cost of the collar, the hedging algorithm was able to use a less expensive put strike than the optimal puts for EIX. For the put leg here, the cost was $725 or 2.5% of position value. The income generated by the call leg, $825 or 2.84% of position value (calculated at the bid), was higher though.
So, the net cost was negative, meaning you would have collected a net credit of $100 when opening this hedge, assuming you placed both trades at the worst ends of their respective spreads.
As I wrote in my PG&E article last month, high optimal put hedging costs can be a warning flag. The optimal put hedging costs for SRE and EIX now are nowhere near as high as PCG's were when its bankruptcy filing was imminent, and SRE's, in particular, are quite low. It might be worth keeping an eye on both of these utilities' hedging costs going forward.
To be transparent and accountable, I post a performance update for my Bulletproof Investing service every week. Here's the latest one: Performance Update - Week 62.
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.