Hedging Update: Social Media Stocks After Facebook’s IPO

Originally posted on Slope of Hope on Saturday:

Last time we looked at the costs of hedging social media stocks, I mentioned Tim’s bearish post on Facebook’s upcoming IPO, and a bearish article by Bloomberg, citing doubts about the company by institutional investors. The bears have so far proved prescient, of course, as Facebook’s stock has continued to deflate following its fizzled IPO. But this week I spotted one Facebook bull on Twitter, early stage tech investor Dave McClure:

McClure bet 37 Signals partner David Hansson (@dhh) a beer that FB would close at $40 or above on the anniversary of its IPO. In response, I noted the high hedging costs of Facebook suggested Hansson was more likely to win that bet:

May 29th was the day options started trading on Facebook, and the article I linked to in the tweet above showed a cost of 19.9% of position value to hedge Facebook against a greater-than-20% drop at the time. The cost of that level of protection on Facebook declined slightly by Friday, to 16.6%, as the stock continued its slide. As expensive as that is, a couple of social media stocks that went public last year are now too expensive to hedge against a 20% drop now. The table below shows the costs, as of Friday’s close, of hedging Facebook, LinkedIN, Zynga, and Pandora against greater-than-28% drops over the next several months, using optimal puts.

Comparisons

For comparison purposes, I’ve added the Global X Social Media Index ETF (SOCL) and the PowerShares QQQ Trust ETF (QQQ) against the same decline. First, a reminder about what optimal puts are, and a note about why I’ve used 28% as a decline threshold this time; then, a screen capture showing the optimal put to hedge one of the comparison ETFs, QQQ.

About Optimal Puts

Optimal puts are the ones that will give you the level of protection you want at the lowest possible cost. Portfolio Armor (available on the web and as an Apple iOS app), 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.

Decline Thresholds

In this context, “threshold” is the maximum decline you are willing to risk. You can enter any percentage you like for a decline threshold when scanning for optimal puts (the higher the percentage though, the greater the chance you will find optimal puts for your position).

Often, I use 20% thresholds when hedging equities, but two of these stocks were too expensive to hedge using 20% thresholds (i.e., the cost of hedging them against a greater-than-20% drop was itself greater than 20%, so Portfolio Armor indicated that no optimal contracts were found for them). There were optimal contracts available for all of these names using a decline threshold of 28%, so that’s the threshold I’ve used below.

The optimal put to hedge QQQ against a greater-than-28% drop

Below is a screen capture of the optimal put option contract to buy to hedge 100 shares of QQQ against a greater-than-28% drop between now and December 21st, 2012. A couple of notes about this optimal put and its cost:

  1. To be conservative, the app calculated the cost based on the ask price of the optimal put. In practice an investor can often purchase puts for a lower price, i.e., some price between the bid and the ask (the same is true of the other names in the table below).
  2. Hedging costs for QQQ have been climbing. Recall that last time we looked at hedging QQQ (using a slightly smaller decline threshold, 27%), the cost as a percentage of position value was only 1.42%.

Hedging costs as of Friday’s close

The table below shows the costs of hedging these names against greater-than-29% declines over the next several months. Costs are presented as percentages of position value. Given the high cost of hedging some of these names, if you own them as part of a diversified portfolio, and are content to let that diversification ameliorate your stock-specific risk — but are still concerned about market risk — you might consider buying optimal puts on an index-tracking ETF (such as QQQ) instead, as a way to hedge your market risk. Or you might consider just selling them.

Symbol Name Hedging Cost
Social Media Stocks
FB Facebook, Inc. 9.56%*
LNKD LinkedIn 15.1%**
P Pandora Media, Inc. 28.1%*
ZNGA Zynga 25.8%*
Comparisons
SOCL Global X Social Media Index 10.6%*
QQQ PowerShares QQQ Trust 2.00%*

*Based on optimal puts expiring in December

**Based on optimal puts expiring in January

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