An IBM computer in the console of the Pan American space plane helps its pilot dock at the space station in 2001: A Space Odyssey (1968). Image via I Like Interfaces.
IBM Takes A Tumble
Here, I’ll show how those hedges ameliorated this slide and talk briefly about what hedged IBM longs can do now. First, though, a quick reminder about the purpose of hedging: you hedge when you are bullish about a security (otherwise you wouldn’t own it) but want to limit your risk in the event you were wrong. IBM longs who hedged in October didn’t expect the stock to drop as much as it has, but wanted to protect themselves in case it did.
The October Optimal Put Hedge
As of October 3rd’s close, these were the optimal, or least expensive, put options to hedge 500 shares of IBM against a >17% decline by mid-April (optimal hedge screen captures via the Portfolio Armor iPhone app).
Note that the cost here was $1,040, or 1.36% of position value (calculated conservatively, using the ask price of the puts).
Let’s look at how that hedge has reacted to the 41% drop.
How The Optimal Put Hedge Has Reacted
Here’s an updated quote on those puts as of Friday’s close (via CBOE):
How That Hedge Ameliorated IBM’s Drop
IBM closed at $151.31 on October 4th. A shareholder who owned 500 shares of it and hedged with the puts above then had $75,655 in IBM shares plus $1,040 in puts, so the net position value was $75,655 + $1,040 = $76,695.
The stock closed at $117.19 on Friday, November 23rd, down about 22.5% from its close on October 4th. The investor’s shares were worth $58,595 on Friday, and the put options were worth $8,000, using the midpoint of the spread. So, the net position value as of Friday’s close was $52,595 + $8,000 = $66,595. $66,595 represents a 13.2% drop from $76,695.
The October Optimal Collar Hedge
On October 4th, this was the optimal collar to protect against a >17% drop in IBM by mid-April, while not capping your possible upside at less than 17% by then.
In this case, the net cost of the hedge was negative, meaning you would have collected a $260 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
In this case, the put leg of the collar used the same strike as in the previous hedge:
And here’s an updated quote on the call leg:
How That Hedge Ameliorated IBM’s Drop
Recall that IBM closed at $151.31 on October 4th. A shareholder who owned 500 shares of it and hedged with the collar above then had $76,655 in IBM shares plus $1,040 in puts, and if the investor wanted to buy to close the short call position, it would have cost him $1,300. So, his net position value on October 4th was ($75,655 + $1,040) – $1,300 = $75,395.
On Friday, the shares were worth $58,595, the put options were worth $8,000, and it would have cost $60 to buy to close his calls, using the midpoint of the spread in both cases. So, ($58,595 + $8,000) – $60 = $66,535. $66,535 represents an 11.8% drop from $75,395.
More Protection Than Promised In Both Cases
Although IBM dropped by about 22.5% from October 4th to November 3rd, and both hedges were designed to protect against a >17% drop, the optimal put hedge limited the drawdown to 13.2%, and the optimal collar hedge limited it to 11.8%. This is another example of the impact of time value on hedges based on intrinsic value alone.
So What Now?
That depends on what you think IBM’s prospects are between now and April, and whether you are a long-term bull beyond that. If you are a long-term bull, then you’re probably not planning to exit. Instead, you might consider selling your puts and using the proceeds to buy more shares. You might also consider buying-to-close your short call leg, if you’re hedged with the collar, to eliminate your upside cap. If you decide that you’re no longer bullish, you can exit now for a smaller loss. The nice thing about being hedged, though, is that it gives you options (no pun intended). You don’t have to worry so much about how much further IBM might drop because you have relatively little downside left from here (you’re not going to be down more than 17% with these hedges). You have breathing space to let the dust settle and decide on your best course of action without the anxiety of an unhedged investor.
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 51.
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.