Good detailed explanation.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…)
A New Competitor For Apple’s Top-Selling Product
According to the most recent 10-Q from Apple, Inc. (AAPL), the company generated more net revenues from selling its iPhone than from any other product — nearly $30.7 billion in 2012. On Thursday night in New York, Samsung (SSNLF.PK) released its latest smartphone competitor to Apple’s iPhone 5, the Galaxy S4; at first glance it looks like a daunting.
Galaxy S4 versus iPhone 5
Reporter Charlie Cook at Mashable compared the Galaxy S4 to the iPhone 5 and other smartphones on Thursday. Here are some key stats from his comparison:
|Galaxy S4||iPhone 5|
|Processor||Quad-core 1.9GHz Snapdragon 600 (in the U.S.)||Dual-core 1 GHz Apple A6|
In addition to having more megapixels, the Galaxy S4’s camera has some unique features. For example, if someone walks through your field of view while you are taking a photo, apparently, you can erase that person’s image from your photo’s background.
Another novel feature of the Galaxy S4 was noted by Bloomberg Tech reporter Katy Finneran on Twitter Thursday night:
– Katy Finneran (@KatyFinneran) March 14, 2013
The Risk For Apple Shareholders
In a recent Seeking Alpha article (“Apple Is Not Worth $460”), value investor Jae Jun made a compelling case for why Apple is undervalued if one assumes low or even zero growth going forward. But what if Apple’s earnings decline in the future? Given rising competition from the likes of the bigger, more powerful Galaxy S4, that seems a real possibility. It’s also worth noting that if Apple’s next iPhone is merely an incremental improvement over the iPhone 5, Apple could face more competition from previous generations of its own products: some iPhone 5 owners may decide not to upgrade, and some owners of earlier models may decide to buy an used iPhone 5.
In his article, Jae Jun said he was bullish on Apple stock as an investment, even though he wasn’t a fan of the company or its products. I actually like my Apple iPhone 4S, but would be wary of downside risk if I owned Apple shares. Apple shares have dropped more than 37% over the last six months. For Apple investors, below are two ways to hedge it against further significant declines over the next several months.
Two Ways Of Hedging Apple Now
Of course, the best time to hedge a stock is before it suffers a significant decline; I noted in an Instablog post in January how those who had hedged Apple back in August had limited their downside by doing so. But sometimes a stock that suffers a significant decline will suffer further ones. Here are two ways for an Apple shareholder to hedge 100 shares against a greater-than-20% drop between now and October.
1) The first way uses optimal puts*; this way allows uncapped upside, but is more expensive. This was the optimal put, as of Thursday’s close, for an investor looking to hedge 1000 shares of AAPL against a greater-than-20% drop between now and October 18th:
As you can see at the bottom of the screen capture above, the cost of this protection, as a percentage of position value, was 2.96%. By way of comparison, the cost, as a percentage of position value, to hedge the Nasdaq 100 Index-tracking ETF PowerShares QQQ Trust (QQQ), over a slightly shorter time frame (until September 20th), was 0.73% of position value.
2) An AAPL investor interested in hedging against the same, greater-than-20% decline between now and October 18th, but also willing to cap his potential upside 20% over that time frame, could have used the optimal collar** below to hedge instead.
As you can see at the bottom of the screen capture above, the net cost of this collar, as a percentage of position value, was 0.20%.
Note that, to be conservative, the cost of both hedges was calculated conservative, using the ask price for the optimal puts and the put leg of the optimal collar, and the bid price of the call leg of the optimal collar; in practice, an investor can often buy puts for some price less than the ask price (i.e., some price between the bid and ask) and sell calls for some price higher than the bid price (i.e., some price between the bid and the ask).
Possibly More Protection Than Promised
In some cases, hedges such as the ones above can provide more protection than promised. For a recent example of that, see this Instablog post about hedging shares of the mining company Cliffs Natural Resources (CLF). That post may also be of interest given that the stock suffered a greater-than-20% decline on the heels of another precipitous 20% drop.
*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 Ph.D 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.