Investors like valuations, but market instability dampens their appetite
A recurring theme of multi-month bear markets is the tension between attractive intrinsic valuations (upside) vs. external headwinds from policy makers, macroeconomic variables, and in the current scenario the risk of a deep recession in Europe driven by the war’s effect on commodity markets.
We isolate Amazon as a good example of an industry leader with a strong and resilient business case – however, the same logic applies to any industry leader with a strong balance sheet and a vibrant business case (e.g., JPM, GS, MSFT, GOOG, etc.).
These companies have had a limited impact from the Covid slowdown, post-Covid inflation, and the war in Ukraine. However, AMZN has lost 25% of its market capitalization year-to-date and is effectively flat since mid-2020.
This strategy neuters short-term volatility but keeps long-term upside
The following strategy allows one to build a long-term, “through the cycle” position in the stock, while limiting the risk of a deeper sell-off.
- Buy 100 shares of AMZN at $126.65 each;
- Buy one December 16th put contract with a $120 strike (5.3% below spot) for $7.75;
- Sell one December 16th call contract with a $140 strike (10.5% above spot) for $5.90; and,
- Sell an October 7th call contract and buy an October 7th call contract striking at $133 and $138, respectively (5% and 9% above spot).
The net cost of the position ($12,702) will be nearly the same as buying the stock outright ($12,665), albeit the call spread would require an extra $500 in collateral.
However, the position itself would be protected from a loss greater than 5.5% (9.1% when including the collateral) by year-end and keep 100% of the upside from 2023 onwards.
What could go wrong?
This strategy offers time-limited risk mitigation. At the expiration of the options by December 16th, the investor would have to decide whether to keep the underlying position fully unhedged, or roll-over the strategy. Also, as with most option strategies, the strength of the protection wanes over time as the value of the option converges to the intrinsic value (which could be zero).
Narrowing the range on the front-end, keeping the wide range on the back end
Stock price performance is driven by a permanent tug-of-war between stock-specific drivers and valuation, and market-wide catalysts. In a bull market, investors normally give more weight to a growing economy and cheap cost of capital than to a single stock’s rich valuation, for example. In a bear market, by contrast, investors that otherwise would be attracted to a cheap valuation or a particularly attractive balance sheet could be pushed back by rising interest rates or a slowing economy.
This strategy offsets part of this tension: it allows investors to capture the perceived upside from a stock’s cheap valuation while neutralizing the short-term volatility created by overarching macro conditions (European recession, Fed hawkishness, etc.).
- The underpinning long-term position is 100 shares of AMZN (or whichever stock the investor prefers),
at a cost of $12,665; - This position is hedged with a December 16th put contract with a $120 strike at a cost of $7.75.
This put contract protects the investor from a loss greater than 5.3%,
but the option itself costs 6.1% of the underlying position;
- To finance the cost of the put, the investor sells a December 16th call contract with a $140 strike for $5.90. The investor thus sacrifices upside greater than 10.5% by the expiration date, but reduces the total cost of the hedge to $1.85 (1.5% of underlying position); and,
- Finally, the investor sells an October 7th call spread to substantially finance the rest of the hedging structure – sells a $133 call, buys a $138 call – for $1.48 in net cash proceeds. This spread would require $500 in collateral that would be clawed if the stock gains more than 9% in the first month
The result is that for a substantially equivalent amount of money the investor can build a position at the current valuation while limiting the effect of price volatility to no more than a 5.3% potential loss.
Thesis and Timing
Some investors do not want to miss the opportunity to build long-term positions at attractive valuations but are nervous about the volatility prevailing in the market. For them, this strategy “freezes” the valuation entry point throughout the rest of the year in anticipation of a more constructive macroeconomic backdrop in 2023 by strangling the effective price movement effecting the position to a -5.3% to +10.5% range by December 16, 2022.
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