Over the last six months, all stock market indexes have made dramatic improvements from the plunge over the October 2007-March 2009 period. The market rally over the last six months is far from the norm and pundits, analysts and investors have adopted a more bearish view in the near term, even though many of them see a brighter longer-term market outlook. An inquiring investor would wonder how to lock in recent portfolio gains should the market at large come under pressure. Sure, one could simply liquidate positions but that has tax implications. Another is to hedge one's positions.
With this in mind, I spoke with Heath Winter, an analyst at Think 20/20 equity research firm, who uses a combination of stocks and options in his event-driven and risk-arbitrage coverage. Here are excerpts from the interview:
Question: Heath, explain how you look at an event-driven investing opportunity?
Answer: In order to attract my initial attention, an investment opportunity has to meet several criteria. First, there has to be a specific event, such as an acquisition, legal development, merger, restructuring, reorganization or special dividend that will create value for a publicly traded company. Second, the event has to be publicly announced - buying stocks or options based on rumor of a coming event or other innuendo is speculating, not investing. Third, the opportunity must have an estimated timeframe, so that an investor can contrast annualized returns from different investment opportunities. I incorporate information from public sources, such as SEC filings and annual reports, with research that is developed through proprietary means, and create an estimate of risk and return.
Q: How do you decide which opportunity to use if there is more than one way to play that opportunity?
A: All things being equal, an investor should choose the investment that will provide the greatest return per dollar at risk. Frequently, investors are presented with a number of different tools they can use to take advantage of an event-driven investment opportunity. These tools include common stock, exchange-listed options, convertible debt and exchange-traded funds, as well as synthetic securities an investor can create through a paired trade. My research process evaluates the distinct risks associated with each investment approach, including the possibility that the risk assessment itself is flawed, and recommends the tactic that will reward an investor with the best available combination of return and risk.
Q: How does using a combination of stocks and/or options help maximize a potential return while minimizing risk?
A: In event-driven investing, the event creates a very specific target value. The premium and discounts that are seen in the markets for listed options can be used to enhance returns, eliminate the risk of incorrect downside estimates or reduce an investor's risk.
For example, consider the recently announced acquisition of Perot Systems Corp. (PER) by Dell Inc. (DELL) for $30 [per share]. If the stock trades at $29, we know that the available return is $1. In addition, we know that prior to the announcement of the acquisition, Perot Systems traded around $18. If the acquisition by Dell is not completed, we can expect that Perot Systems' stock price will return to its prior level. An investor that buys Perot Systems' stock at $29 is risking $11 (the difference between the pre-deal price and the current price) to earn $1, or a return-on-risk of 9.1 percent.
We can expect the transaction to close in mid-January. That information is useful because it allows for the calculation of the return on an annualized basis; it's also useful because we can examine the market for call and put options on Perot Systems' stock that expire in January.
In the above example, the investor stands to earn $1. If, in addition to buying the Perot Systems' stock for $29, the investor sells (also known as writing) call options for 50 cents that (a) expire in January and (b) have a strike price of $30, then that investor now stands to earn $1.50. The risk faced by the investor is unchanged, the downside if the acquisition is not completed remains the same. But the return-on-risk has been improved to 13.6 percent.
Q: Can the average investor use some of the same tools described above to hedge their portfolios?
A: Any investor that is able to identify risk can use stocks, options, debt or exchange-traded funds to hedge that risk. For example, an investor with a portfolio that includes heavy weighting toward their employer's stock could write call options to improve his or her return while experiencing the same risk profile. Alternatively, the same investor could buy put options to hedge of the risk of a stock price decline. The hardest part would be identifying an appropriate time duration ... but that issue could be addressed by using a ladder of expirations the same way many investors use a ladder for their certificates of deposit.
Q; What would some other ways for them to hedge the market be, given the substantial move over the last six months should they opt to do so?
A: It's understandable, given the dramatic surge in the stock market valuation, that investors are looking for a means to protect themselves against a decline. An investor who feels that six months from now there will be better clarity regarding market volatility could purchase put options on the S&P Deposit Receipts (SPY), whose performance mimics the S&P 500 index. Currently, SPY trades for about $106. A March put option on SPY with a strike of 100 can be purchased for $5, effectively protecting against a decline in SPY below $95. SPY last traded below $95 on July 22.
Chris Versace is director of research at Think 20/20 LLC, an independent research and corporate access firm based in Reston. He can be reached at firstname.lastname@example.org. At the time of publication, Mr. Versace had no positions in companies mentioned. However, positions can change.