The Hedge That Continues To Help JC Penney Longs

Shares of JC Penney JCP hit a 31-year low on Friday, as the stock dropped below $8 per share. Recall that we posted a way to hedge JCP a couple of months ago ("Getting Paid To Hedge Bill Ackman's Riskiest Investment") In this post we'll look at how that hedge has protected JCP shareholders so far.

Our August 13th JC Penney Hedge

This was the optimal collar*, as of August 13th's close, designed to limit an investor's losses to 17% over the following six months, for an investor 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 $50 to hedge.

How That Hedge Has Reacted To JCP's Drop

Here is an updated quote on the put leg as of Friday:

And here is an updated quote on the call leg:

How That Hedge Protected Against Today'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 traded at $7.88 intraday Friday, October 4th, down 38% from its price on August 13th. The investor's shares were worth $7,880 as of intraday Friday, his put options were worth $3,650 and if he wanted to close out the short call leg of his collar, it would cost him $280. So: ($7,880 + $3,650) - $280 = $11,250. $11,250 represents a 11% drop from $12,630.

More Protection Than Promised

So, although JCP had dropped by 38% 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 only 11% on his combined hedge + underlying stock position by this point.

Options Give You Options

Being hedged gives an investor breathing room to decide what his best course of action is. A JC Penney investor hedged with this collar could exit his position with an 11% loss now (instead of a 38% loss), he could wait to see what happens, or if he remains a long term bull, he could buy-to-close the call leg of this collar, to eliminate his upside cap. If he's even more bullish, he could sell his appreciated puts, and use those proceeds to buy more JCP shares at a 31-year low. He has those options because he's hedged.

*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.