Biotech stocks took a beating on Friday, with the ETF that tracks them, iShares Nasdaq Biotechnology (IBB), down 4.74% on the day. One of the harder hit biotechs was Biogen (BIIB), which was down 8.22% on the day. Despite the drop, Biogen had one of the 10 highest expected returns of the securities in Portfolio Armor’s universe as of Friday’s close. In case its actual return over the next several months ends up being in the opposite direction, here are a couple of ways to hedge it.
1) Hedging With Optimal Puts
6.9% cost. Uncapped upside.
As of Friday’s close, these were the optimal puts* to hedge 300 shares of BIIB against a greater-than-20% 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 6.91%.
2) Hedging With An Optimal Collar
Pays you to hedge. 20% upside cap.
If you were willing to cap your potential upside at 20% between now and October 17th, this was the optimal collar** to hedge 300 shares of BIIB against a greater-than-20% drop over the same time frame.
As you can see at the bottom of the screen capture above, the net cost of this collar was negative, meaning you would collect more in income from selling the call leg than you’d pay to buy the put leg of this collar.
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 collected more than $540 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 biotech stock – InterMune (ITMN) – 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.