What do Cannabis, Nelson Peltz and Hedging Have in Common?

On March 13^th, Aurora Cannabis Inc. (TSX: ACB) announced that they had appointed Nelson Peltz as a Strategic Advisor to help explore potential partnerships and advise on the company’s global expansion strategy.

This is a big deal given Mr. Peltz’s business history and reputation for delivering results. For more details around this new relationship, check out this TMX Money article: Aurora Cannabis Appoints Nelson Peltz as Strategic Advisor.

The impact of this decision can be clearly seen in the price action of the stock as noted in chart 1.

Chart 1: Aurora Cannabis Weekly

Source: www.tradingview.com

While the current trend appears to be on the upside, history has shown us that stocks within the cannabis sector are volatile.

Understanding volatility is critical to determining which option strategy may give us the best chance at profiting from a directional bias on a stock.

There are two types of volatility to consider:

1. Historical Volatility (HV)

A measure of the deviation in price for a stock above or below its average. The greater the share price trades above or below the average, the higher the historical volatility.

2. Implied Volatility (IV)

This is factored into the price of an option contract and reflects the anticipated future movement in the underlying share price. The more uncertain the future share price of the company, the higher the implied volatility.

It should be noted that stocks with a higher historical volatility will typically have options with higher implied volatility.

Table 1 compares the current HV and IV of Aurora Cannabis (TSX: ACB) to iShares S&P/TSX 60 ETF (TSX: XIU)

Table 1: Historic Volatility vs. Implied Volatility

Clearly TSX: ACB is the more volatile of the two.

Let’s tie this into something that we can use in our strategy selection process if we feel that the decision to bring in Nelson Peltz as a Strategic Advisor supports further upside for the stock.

If we were to consider buying shares of the company, adding a Protective Put or Married Put would be a way to hedge our risk on a perpetually volatile stock. For a brush up on this Protective Put strategy, CLICK HERE.

This would allow us to participate in the upside, with a limited and identifiable risk exposure until the put option purchased expires or until we choose to close the position.

That said, buying a put option to hedge risk can be compared to buying car insurance, the more unpredictable the driver, the more expensive the insurance. In the options market, as risk and uncertainty increase, so does the price of the “insurance policy” or put option in this case.

Consider the following:

Table 2: The Protective Put Example (As of March 27th)

Since the share purchase price and the strike price of the put are the same, this leaves the cost of the put option as the maximum risk, which represents 11.25%. Overcoming the breakeven point would require an 11.25% jump in the share price.

If hedging the risk on this opportunity seems cost prohibitive due to the expensive nature of the options market, the Collar Strategy is a great way to offset the cost. If you need a refresher on this hedging strategy, CLICK HERE to review.

The Protective Collar will allow for upside participation on the stock (albeit limited) while reducing the cost of the hedge.

The strategy:

1. Offsets the volatility premium paid
2. Lowers the breakeven point
3. Lowers the maximum risk

Consider the following:

Table 3: The Protective Collar Example

The upside is limited to $15.00. This works out to be approximately 17.00%, an annualized return of 102.00%.

The maximum risk has been reduced to 8.00%.

By selling the call, we reduce the cost of the hedge. Our breakeven point is now lowered requiring less of a jump to break even and we have an attractive risk/reward opportunity.

So, what does cannabis, Nelson Peltz and hedging have in common? By understanding a couple of simple option strategies used for hedging and the impact of volatility on option pricing, you can take advantage of a positive headline associated with a volatile stock with a limited and identifiable risk exposure.

The strategies presented in this blog are for information and training purposes only, and should not be interpreted as recommendations to buy or sell any security. As always, you should ensure that you are comfortable with the proposed scenarios and ready to assume all the risks before implementing an option strategy.