Early Gains For Portfolio Armor Pick Applied Materials
Earlier this month, Applied Materials (NASDAQ:AMAT) was one of Portfolio Armor’s top-ranked names, appearing in this hedged portfolio we shared on Twitter (NYSE:TWTR) on August 10th, alongside the Global X Gold Explorers ETF (NYSEARCA:GLDX), Insperity (NYSE:NSP), Outerwall (NASDAQ:OUTR), and Shenandoah Telecom (NASDAQ:SHEN):
So the tweet above from Investor’s Business Daily, noting that AMAT had hit a 16-year high on its record third quarter caught our eye. Since August 10th, the stock is up more than 12%, as of Friday’s close.
Applied Materials has dropped a bit in Portfolio Armor’s ranking since then, but it’s still in the site’s Top 50. For AMAT longs looking to lock in some gains here and hold for more by adding downside protection, we’ll look at a few ways of doing so below.
Downside Protection For Applied Materials
If you’d like a refresher on hedging terms first, please see the section titled, “Refresher On Hedging Terms,” in this previous article of ours, Locking In Gold Gains).
Hedging Applied Materials With Optimal Puts
We’ll use Portfolio Armor’s iOS app to find optimal puts and two optimal collars to hedge AMAT, but you can find optimal puts and collars without the app by using the process we outlined in this article, if you’re willing to do the work. Either way, you’ll need to know your “threshold,” which is the maximum decline you are willing to risk. This will vary depending on your risk tolerance. For the examples below, we used thresholds of 18%. If you are more risk-averse, you could use a smaller one. All else equal though, the smaller the threshold, the more expensive it will be to hedge.
As of Friday’s close, these were the optimal puts to hedge 1000 shares of AMAT against a greater-than-18% decline by late January.
As you can see above, the cost of this protection was $600, or 2.02% of position value. A few notes about this hedge:
- To be conservative, the cost was calculated using the ask price of the puts. In practice, you can often buy puts for less (at some price between the bid and ask).
- The threshold includes the cost; in the worst-case scenario, your position would be down 15.98%, not including the hedging cost.
- The threshold is based on the intrinsic value of the puts, so they may provide more protection than promised if the underlying security declines in the near term, when the puts may still have significant time value.
If you want to reduce the cost of hedging without increasing your threshold, you can try hedging with a collar instead.
Hedging AMAT With An Optimal Collar
When hedging with collars, you need another number in addition to your threshold, your “cap,” which refers to the maximum upside you are willing to limit yourself to if the underlying security appreciates significantly. As of Friday, the Portfolio Armor website estimated a potential return of 18% for AMAT over the next several months, so we used that as a cap.
As of Friday’s close, this was the optimal collar to hedge 1000 shares of AMAT against a greater-than-18% drop by late January, while not capping an investor’s upside at less than 18% by then.
As you can see above, the put strike was the same as in the optimal puts, so the cost was the same, or $600 or 2.02% of position value. But, as you can see below, the income generated from selling the call leg was $290, or 0.98% of position value.
So the net cost of this hedge was $310, or 1.05%. Similar to the case with the optimal puts, the cost here was calculated conservatively, using the ask price of the puts and the bid price of the calls, so the actual cost of this hedge would likely have been less than $310. But if you don’t want to pay anything to hedge, you can try using a tighter cap. Below is an example of that.
Hedging Applied Materials With A Tighter Collar
As of Friday’s close, this was the optimal collar to hedge 1,000 shares of AMAT against a >18% decline by late January, while not capping your upside at less than 11% by then.
As you can see above, it’s the same put strike again, so it has the same cost; $600, or 2.02% of position value. But this time, the income from selling the call leg is higher, $630, or 2.13% of position value.
So the net cost this time is negative, meaning an investor opening this hedge would collect an amount equal to $30, or 0.1% of position value, calculated conservative. One note on the two collar hedges:
- These hedges may provide more protection than promised if the underlying security declines in the near future (and the investor exits then) due to time value (for an example of this, see this recent article on Hedging Apple). However, if the underlying security spikes in the near future, time value can have the opposite effect, making it costly to exit the position early (for an extreme example of this, see this article on hedging the Direxion Daily Gold Miners Index Bull 3x Shares ETF (NYSEARCA:NUGT) (Gold Miners Head To The Moon).
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 Unique Finance). I have no business relationship with any company whose stock is mentioned in this article.