Adding Downside Protection To Amazon

Shares of Amazon (NASDAQ:AMZN) rose nearly 4% Thursday, ahead of the company's earnings release after hours. Amazon reported a 28% year-over-year increase in quarterly earnings, which was inline with analysts' expectations, and a 23% year-over-year increase in revenues, which beat analysts' expectations modestly. Shares traded up a quarter percent more after hours on the news. For Amazon longs looking to add some downside protection, here are a couple of ways to do so.

1) Hedging With Optimal Puts

6.14% cost. Uncapped upside.

As of Thursday's close, these were the optimal puts* to hedge 1000 shares of AMZN against a greater-than-12% drop over the next several months.

As you can see at the bottom of the screen capture above, the cost of this protection, as a percentage of position value, was 6.14%.

2) Hedging With An Optimal Collar

0.15% cost. 12% upside cap.

If you were willing to cap your potential upside at 12%, this was the optimal collar** to hedge 1000 shares of AMZN until October 17th.

As you can see at the bottom of the screen capture above, the net cost of this collar, as a percentage of position value, was 0.15%.

Note that, to be conservative, Portfolio Armor calculated the cost of this hedge by using the bid price of the call leg and the ask price of the put leg. In practice, you can often sell calls for more (at some price between the bid and ask) and buy puts for less (again, at some price between the bid and ask), so, in actuality, an investor opening the collar above may have paid less than $500 to do so.

Maximizing Return While Limiting Downside Risk

Optimal puts and optimal collars on securities with high expected returns can be used to build a hedged portfolio around a position, in order to maximize potential return while limiting downside. For an example of a hedged portfolio constructed around another tech stock - Microsoft (NASDAQ:MSFT) - see this post.

*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 PhD 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 Portfolio Armor iOS app.