Softening The Blow For JC Penney Longs

Shares of JC Penney JCP dropped nearly 15% Wednesday, after Goldman Sachs GS warned of the company’s risk of bankruptcy. I posted a way to hedge JCP last month (“Getting Paid To Hedge Bill Ackman’s Riskiest Investment”). In this post we’ll look at how that hedge would have softened the blow for JCP longs on Wednesday.

This was the hedge we posted last month, an optimal collar* designed to limit an investor’s losses to 17% over the next six months, if the investor were willing to cap his upside at 10% over the same time frame:

As you can see at the bottom of the screen capture above, the net cost of that optimal collar was negative, meaning the investor would have gotten paid to hedge.

How That Hedge Reacted To JCP’s Drop

Here is how the put leg reacted on Wednesday:

And here is how the call leg reacted:

How That Hedge Protected Against Wednesday’s Drop

JCP closed at $12.68 on August 13th. A shareholder who owned 1000 shares of it and opened the collar above on August 13th had $12,680 in JCP stock plus an outlay of -$50 on the hedge, so $12,630 taking into account the hedge.

JCP closed at $10.12 today, down 20% from its price on August 13th, so the investor’s shares are now $10,120, his put options are worth $2,390, and if he wanted to close out the short call leg of his collar, it would cost him $600. So: ($10,120 + $2,390) - $600 = $11,910. $11,910 represents a 5.7% drop from $12,630.

More Protection Than Promised

So, although JCP had dropped by 20% at the time of the calculations above, and the investor’s hedge was designed to limit him to a loss of no more than 17%, he was actually down less than 6% on his combined hedge + underlying stock position at this point.

*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. Portfolio Armor's 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.