Hedging the Bursting of Internet Bubble 2.0

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Hey fellow Slopers,

A conversation I had earlier this week with an NYC-based Internet entrepreneur prompted me to think about the current Internet bubble and how one might hedge against it with protective puts. More about that below, but first a quick reminder: if you want to enter the contest I mentioned in a post earlier this month to win an iPad 2 for posting a comment about a stock, there's one week left to do that. More details at that link. On to today's post.

The entrepreneur I alluded to above was Jesse Middleton, co-founder of GetMinders1 and WeWork Labs. Prior to founding GetMinders, Jesse was the director of IT at LivePerson, Inc. (LPSN). When we met for dinner Tuesday night, Jesse brought up South by Southwest, which he attended. That reminded me of this tweet of his from the conference last week:

Our conversation about that tweet, in turn, got me thinking about ways one could hedge against a bursting of the New Internet Bubble using protective puts. Consider a business owner whose revenues were closely tied to the fortunes of privately-held, venture-backed start-ups in the sector: he couldn’t hedge against a collapse in those companies directly, but he could buy put protection against a big correction in some publicly traded securities in the Internet sector, as an indirect hedge. A couple of ideas came to mind:

1) Buying puts on Internet ETFs.

Judging by their top 10 holdings, the First Trust Dow Jones Internet Index ETF (FDN), is more diversified than the Merrill Lynch Internet HOLDRs ETF (HHH), which has nearly 40% of its assets in Amazon.com (AMZN). Below are the put option contracts Portfolio Armor presented as the optimal ones to hedge against greater-than-25% declines in these ETFs, but first a quick reminder about what “optimal” means in this context: The optimal put option contracts are the ones that will give you the precise level of protection you want at the lowest possible cost. Portfolio Armor uses a proprietary algorith developed by a finance Ph.D. candidate to find the optimal contracts to hedge stocks and ETFs.



One note about the wide difference between the “initial cost” and “current value” Portfolio Armor shows for the optimal put option contract for FDN: to be conservative, Portfolio Armor uses the “ask” to calculate initial cost (“current value” is based on the “last” price). In practice, an investor might be able to buy the contracts for less than the ask price (i.e., some price between the bid and ask). Going by the ask price though, the cost of hedging against a greater-than-25% drop in FDN is pretty high: 6.72% of the position value. The cost of a similar hedge on HHH is 2.25% of position value.

2) Buying puts on a basket of Internet stocks.

The first candidate I thought for this basket was Open Table (OPEN), based partly on something Howard Lindzon wrote about the company on his blog last fall:

Nobody liked OpenTable.com when they went public in 2009. It has only tripled in 2010. OpenTable.com has the distribution with the restaurateurs and the brand name with the consumer. It took 10 plus years to get there. With $80 million in sales and $1.5 billion in market cap most smart people I know think it’s overvalued. That was 30 points ago. OpenTable.com will buy any talent and feature it needs. It is a much smarter way to own these fancy new start-ups and that is what the big money is doing. These momentum spurts can last much longer than you think. They are not that complicated. It helps to understand what’s happening in the start-up world at any given time and that’s why I love the intersection where I sit.

The “intersection” Lindzon referred to to there is between his roles as an investor in publicly-traded companies, and as an entrepreneur and angel investor in start-ups. Other candidates I thought of were Amazon.com (AMZN), Netflix (NFLX), Salesforce.com (CRM), and Internet infrastructure plays Akamai Technologies (AKAM) and Juniper Networks (JNPR). Of those, AMZN, OPEN, and CRM had the highest valuations on a PEG basis, ranging from 2.01 for AMZN to 3.08 for CRM. Portfolio Armor presented these as the optimal put option contracts to hedge against greater-than-25% declines in these stocks:



The cost of hedging against greater-than-25% drops in these stocks is, respectively, 3.17% of position value for AMZN, 4.79% for CRM, and a lofty 11.56% for OPEN — an average cost of 6.5% of position value for the basket.

Hedging in this manner with the stocks or ETFs above isn't cheap right now. All else equal though, it would of course, be cheaper to hedge with the same stocks and ETFs if you used a higher threshold for declines, e.g., hedging against a greater-than-30% decline instead of a greater-than-25% decline.

1Getminders sends automated health-related reminders via phone or text. I mentioned to Jesse that the web version of Portfolio Armor sends out automated notifications as well, via e-mail (the lower priced iPhone app version does not). I received this one today:

Dear Dave Pinsen:

Your puts on the position(s) below are going to expire within a week. You may want to buy new puts on the security before the current puts expire. Please log into Portfolio Armor to determine the optimal puts to buy based on the level of protection you specify.

SPY110319P00094000 – 2011-03-30

QQQQ110319P00039000 – 2011-03-30

If you wish to turn off email notifications, please sign in to Portfolio Armor and click manage account.