Market Overview

Hedging Cliffs Natural Resources After Its 20% Dive On Wednesday

Fidelity Clients Catch Another Falling Knife

In a recent post, we noted that, as shares of Nuance Communications, Inc. (Nasdaq: NUAN) plummeted more than 18% post-earnings, Fidelity customers were net buyers. Fidelity customers were net buyers of another plummeting stock on Wednesday, Cliffs Natural Resources, Inc. (NYSE: CLF), which fell nearly 20% a day after announcing a cut in its dividend in addition to a previously announced writedown.

As the screen capture below from Fidelity's website shows, there were more net buy orders from Fidelity clients for CLF on Wednesday than for any other stock.

According to Fidelity, 70% of CLF orders placed by its customers on Friday were buy orders.

Why Consider Hedging CLF After Its Big Drop

Of course, it's better to hedge a security before it suffers a big drop, than after. But given the buy interest shown by retail investors in CLF on Wednesday, and the possibility that CLF shares may decline further in the future, in this post we'll look at two ways CLF investors can hedge against a greater-than-20% drop in the stock from its current price.

Why Consider Hedging Against A >20% Drop

A twenty percent decline threshold is worth considering, because it lowers the cost of hedging somewhat (all things equal, the larger the potential loss you are looking to hedge against, the less expensive it is to hedge), and because a 20% decline is not necessarily an insurmountable one. To recover from a 20% loss, an investor would need a 25% rebound in his stock. But to recover from, say, a 35% drop, would require a rebound of nearly 54%.

Two Ways To Hedge CLF

The first way uses optimal puts*; this way has a cost, but allows uncapped upside. These are the optimal puts, as of Wednesday's close, for an investor looking to hedge 1000 shares of CLF against a greater-than-20% drop between now and July 19th:

As you can see in the screen capture above, the cost of those optimal puts, as a percentage of position, is 6.93%. 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). By way of comparison, the current cost of hedging the SPDR S&P 500 ETF (NYSE: SPY) against the same decline, over a somewhat longer time frame (until September 20th), is 0.83% of position value.

A CLF investor interested in hedging against the same, greater-than-20% decline between now and July 19th, but also willing to cap his potential upside at 16% over that time frame, could use 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 CLF investor would be getting paid to hedge in this case.

*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.

Posted-In: Markets Trading Ideas

 

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