Crash Protection For Boeing

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About: The Boeing Company (BA), Includes: EADSF, EADSY
by: David Pinsen
Summary

The market's initial reaction to the Ethiopian Airlines crash was an overreaction.

Boeing is still part of a duopoly in large airliners and will work to prevent future crashes.

Nevertheless, for shareholders who want to stay long but strictly limit their risk, I present two ways to do so.

An Ethiopian Airlines 737-800 Max, the same type that crashed on Sunday. (Photo via Alex Macheras).

Putting Boeing's Challenge In Perspective

With the threat of more airlines grounding the 737 Max after Sunday's Ethiopian Airlines crash, below I'll show a couple of ways that Boeing (BA) shareholders can stay long while limiting their risk. Before that, a few general thoughts about Boeing.

  • The market initially overreacted to the Ethiopian Airlines crash. The 10% pre-market drop Monday made little sense given that Boeing is half of a duopoly in the market for large airliners. That may change in the future, but for now, it's Boeing and Airbus (OTCPK:EADSF) (OTCPK:EADSY), and a plane crash or two, as tragic as they are, won't change that reality.

Tweet via Joe Weisenthal

  • Part of the reaction to the Ethiopian Airlines crash was due to it being the second 737 Max crash in 5 months. The earlier crash, that of a Lion Air flight in Indonesia in October, may have been due to an issue with an automated system called MCAS (Maneuvering Characteristics Augmentation System). Judging by the New York Times's analysis of it last month, the problem may have been more with pilot training than the system itself, which is designed to push the plane's nose down to avoid stalls (there is a procedure to switch off MCAS if it activates at the wrong time that pilots need to know). It's possible that Boeing will need to recommend additional simulator training to pilots after its upcoming software update, but as Dhierin Bechai pointed out, demand is high for the 737 Max, so I assume it should remain so even if airlines have to give their pilots additional simulator training on it.
  • I've been presenting Portfolio Armor's top ten names to my Marketplace subscribers every week since June of 2017, and Boeing was a top ten name last week, based on total returns and options market sentiment, as it has been, periodically, since August of 2017. It did drop out of the top ten on Monday, but my system is still bullish on it.

Now let's look at how to stay long Boeing while limiting your risk.

Adding Downside Protection To Boeing

For these two examples, I'll assume you own 500 shares of Boeing and are willing to tolerate a 20% drawdown over the next several months, but not one larger than that. The screen captures below are via the Portfolio Armor iPhone app.

Uncapped Upside, Positive Cost

As of Monday's close, these were the optimal, or least expensive, puts to hedge BA against a >20% drop by mid-August.

Optimal Put hedge on Boeing via Portfolio Armor

The cost of this protection was $3,875, or 1.94% of position value, calculated conservatively, at the ask (in practice, you can often buy and sell options at some price between the bid and ask).

Capped Upside, Negative Cost

If you were willing to cap your possible upside at 14%, this was the optimal collar to give you the same level of protection over the same time frame.

Optimal Collar Hedge on Boeing via Portfolio Armor.

A couple of differences you can see with this hedge. The first is that, after an iterative process taking into account the net cost of the collar, the hedging algorithm was able to use a less expensive strike for the put leg, one where the cost was $3,000 or 1.5% of position value, calculated conservatively, at the ask. The second difference is that the income generated by the short call leg was higher: $3,500, or 1.75% of position value, calculated conservatively, at the ask.

So the net cost of this hedge was negative, meaning you would have collected a net credit of $500 when opening it, assuming you placed both trades at the worst possible ends of their respective spreads.

Wrapping Up

If the recent crashes were due to issues with the MCAS system, whether due to problems with the system itself, due to insufficient pilot training, or a combination of both, I'm confident Boeing will correct them. Nevertheless, hedging here may make sense if you can't tolerate a large decline in the stock.

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.