Hedging Amarin Corporation PLC
As part of its 10k released yesterday, Amarin Corporation, PLC (NASDAQ:AMRN) provided the details on its December 2012 round of financing. Dr. Andrew Goodwin, of Biotech Due Diligence, was unimpressed with the terms, as he noted on Twitter:
For AMRN longs considering adding downside protection to the stock here, we'll look at three different hedging scenarios for it. First, though, a note about the challenge of hedging a stock such as AMRN with protective puts.
When A Stock Is Expensive To Hedge With Protective Puts
In some cases, the cost of protecting a stock with protective puts is more expensive than the loss you are looking to hedge against. That was the case with AMRN on Thursday, if you were looking to hedge against a greater-than-20% drop in the stock over the next several months -- the cost of doing so would have been more than 20% of your position value. The lowest decline threshold at which it was possible to hedge the stock with protective puts without the protection costing more than the decline threshold was 23%, so 23% is the decline threshold we'll use in the first two examples below.
Three Ways To Hedge AMRN
The first way uses optimal puts*; this way allows uncapped upside, but is extremely expensive. AMRN was so expensive to hedge that the These are the optimal puts, as of Thursday's close, for an investor looking to hedge 1000 shares of AMRN against a greater-than-23% drop between now and September 20th:
As you can see in the screen capture above, the cost of those optimal puts, as a percentage of position, is 21.65%. Note that, to be conservative, cost here was calculated using the ask price of the optimal puts; in practice an investor can often buy puts for a lower price (i.e., some price between the bid and the ask). Nevertheless, this is a hugely expensive insurance policy on the stock.
An AMLN investor interested in hedging against the same, greater-than-23% decline between now and September 20th, but also willing to cap his potential upside at 23% over that time frame, could have used the optimal collar** below to hedge instead.
As you can see at the bottom of the screen capture above, the net cost of this optimal collar is negative -- meaning the AMRN investor would be getting paid to hedge in this case.
Finally, an investor looking to hedge using a smaller decline threshold, 15%, and willing to cap his upside at 20% between now and September 20th, could have used this optimal collar to hedge 1000 shares of AMRN.
As you can see at the bottom of the screen capture above, as a percentage of position value, the net cost of this optimal collar was 0.37%.
*Optimal puts are the ones that will give you the level of protection you want at the lowest possible cost. Portfolio Armor uses an algorithm developed by a finance Ph.D to sort through and analyze all of the available puts for your stocks and ETFs, scanning for the optimal ones.
**Optimal collars are the ones that will give you the level of protection you want at the lowest net cost, while not limiting your potential upside by more than you specify. The algorithm to scan for optimal collars was developed in conjunction with a post-doctoral fellow in the financial engineering department at Princeton University.
The screen captures above come from the latest build of the soon-to-come 2.0 version of the Portfolio Armor iOS app. Optimal collar capability will be available as an in-app subscription in the 2.0 version of the app.