Crash Protection For Broadcom

About: Broadcom Inc. (AVGO)
by: David Pinsen

Recently, a fellow Seeking Alpha contributor noted what he saw as an "extremely bearish" indicator for Broadcom ahead of its earnings: its put/call ratio.

In the event this indicator proves prescient, I present ways cautious Broadcom bulls can stay long while strictly limiting their risk.

I close by pointing out another potentially bearish indicator, while noting why I currently give the stock a neutral rating.

Image via YouTube. Broadcom CEO Hock Tan at the White House in 2017 (still from The Star's YouTube video).

A Bearish Indicator For Broadcom

Seeking Alpha contributor Rick Pendergraft, operator of The Hedged Alpha Strategy Marketplace service, offered a bullish take on Broadcom (AVGO) recently, while noting one "extremely bearish reading":

The one sentiment indicator that shows extreme pessimism toward Broadcom is the put/call ratio. The current reading is at 2.07 and that is extremely high. There are 53,572 puts open at this time and 25,773 calls. The put/call ratio was at 0.83 when the company announced back in June. This means that the pessimism is higher than most stocks and the pessimism has been growing over the last three months.

In the event that bearish put/call ratio proves prescient ahead of Broadcom's earnings release, below I'll show different ways cautious bulls can stay long while limiting their risk. Along the way, I'll note another potentially bearish indicator that may be worth keeping an eye on.

Different Forms Of Downside Protection For Broadcom

With Broadcom scheduled to release its earnings on Thursday, I thought it would be instructive to look at optimal, or least expensive, static hedges for it expiring at the end of this week, versus hedges with similar parameters expiring in two months. To highlight the difference in cost, I have circled the dollar cost for each hedge in red.

Uncapped Upside, Expires Friday

As of Tuesday's close, these were the optimal put options to hedge 1,000 shares of Broadcom against a greater-than-10% decline by Friday's close.

Optimal hedge for Broadcom via Portfolio Armor. The cost here was $1,000, or 0.34% of position value, calculated conservatively, using the ask price of the puts (in practice, you can often buy and sell options at some price between the bid and ask).

Capped Upside, Expires Friday

If you were willing to cap your possible upside at 6% by Friday's close, this was the optimal, or least expensive, collar to protect you against the same, greater-than-10% decline by then.

Optimal hedge for Broadcom via Portfolio Armor. Optimal hedge for Broadcom via Portfolio Armor. Optimal hedge for Broadcom via Portfolio Armor.

Here, the cost was negative, meaning you would have collected a net credit of $250, or 0.08% of position value when opening this hedge (assuming, conservatively, that you bought the puts at the ask and sold the calls at the bid).

Uncapped Upside, expires in November

This was the optimal put hedge, as of Tuesday's close, to hedge against a >10% decline by mid-November.

Optimal hedge for Broadcom via Portfolio Armor. The cost here is $10,900, or 3.7% of position value - it's nearly 11 times the cost of the hedge expiring this week.

Capped Upside, Positive Cost

Here's the optimal collar expiring in mid-November. Like the previous optimal collar, it's capped at 6% and protects against a greater-than-10% downside. The only difference we inputted here was that we set the expiration date to the November expiration.

Optimal hedge for Broadcom via Portfolio Armor.

Optimal hedge for Broadcom via Portfolio Armor. Optimal hedge for Broadcom via Portfolio Armor.

Unlike in the previous collar, this one has a positive cost: $2,700, or 0.92% of position value (calculated conservatively, as with the previous one, assuming you placed both trades - buying the puts and selling the calls - at the worst ends of their respective spreads).

Wrapping Up: The Other Potentially Bearish Indicator

The other potentially bearish indicator here is the positive cost on the optimal collar expiring in mid-November. All else equal, you would expect options expiring later to be more expensive, and that's what has happened here. But the reason the collar expiring in November had a positive cost is that put leg got more expensive than the call leg did as we extended the expiration out to November. That November expiration put options further out-of-the-money cost more than November call options not as far out-of-the-money suggests that options market participants are more bearish than bullish about Broadcom's prospects over the next two months. I have nevertheless given Broadcom a neutral rating here, as my site estimates a positive, but below market, return for it over the next several months.

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.