In a tumultuous market, portfolio protection is always nice. Even strong stocks breaking out to new highs can easily fail if market sentiment turns sour. Today, we will look at how a put option on PepsiCo could help protect an investor's portfolio in the event of a market crash.
While the easiest way to protect a portfolio is buying puts on stocks the investor holds or buying a put on the SPDR S&P 500 ETF, there are many downsides to this strategy. Buying puts on stocks can seem appealing, but that's not smart to do with stocks an investor thinks will outperform. Puts on the S&P 500 are effective in hedging, though typically overpriced because of their effectiveness as a hedge.
Defensive-Stock Options Can Offer Protection
Defensive-stock options can offer the opportunity to buy protection at a lower cost than index options. Because these companies are stable, most of their volatility comes from the broader market. One stock investors can consider as a potential hedge is PepsiCo.
PepsiCo stock currently has an implied volatility of 19% and an I.V. rank of only 32 for the options expiring on May 20. Over the past month, PepsiCo has realized 20% annualized volatility. The stock is forming a cup base with a 177.34 buy point.
Buying a PepsiCo May 20, 170 put currently has a cost of $3.80. Since an investor cannot lose more than the premium paid, the $380 can be considered the position's maximum loss. The trade makes money as long as the share price remains below 170 by expiration, and the cost of the premium is covered.
But while you may not make any money on this trade, it works as an insurance policy in case of disaster in the stock market.
This put option currently has a delta of -43, which is equivalent to being short 43 shares of Pepsi at the trade's inception.
PepsiCo Stock Earnings Risk
PepsiCo will report first-quarter earnings on April 26, with EPS estimated at $1.22 and revenue at $15.5 billion. Earnings could be another source of added volatility for PepsiCo, albeit past earnings moves have traditionally been muted. Investors can consider closing the position before the company releases earnings, or hold to expiration.
The best-case scenario for this put option is a market meltdown. An example is the March 2020 Covid-19 crash. Despite a business relatively insulated from the pandemic, PepsiCo realized a volatility of 98% and experienced a drawdown of more than 30%.
While providing great protection for major market drawdowns, this hedge has risk that in a smaller correction PepsiCo could outperform stocks in an investor's portfolio. Nevertheless, it is also possible that this put option could have some value even if the market rallies if PepsiCo stock underperforms.
PepsiCo has an IBD Composite Rating of 85 and an EPS Rating of 65.
