How to Hedge a Plunge in Chip Stocks

Semiconductor stocks have given investors a wild ride so far in 2018, especially since U.S. chip makers rely on global supply chains with particular exposure to Asia. Trade tensions with China have been a major source of anxiety among investors even as chip stocks initially rose as both governments took steps to avoid a trade war. Despite talks of a truce over the weekend, recent comments by President Trump on Tuesday have heightened China-U.S. trade tensions, rendering a hedging investing strategy even more important. No matter what the outcome of these unpredictable trade talks, Credit Suisse has outlined a strategy by which investors can profit from further upside in chip stocks while limiting the downside, Barron's reports.

Applied Materials Inc. (AMAT) is a prime example of how volatile these stocks can be. This leading supplier of capital equipment for chip production saw its share price plunge by more than 8% on May 18, following lowered projections of revenue and earnings for the current quarter, CNBC reports. Meanwhile, analysis of options trading indicates that Micron Technology Inc. (MU) and Nvidia Corp. (NVDA) are expected by investors to be among the most volatile stocks in the S&P 500 Index (SPX) during the next month, per data from Trade Alert cited by Barron's. (For more, see also: Are Red-Hot Semiconductor Stocks Top Heavy?)

Rollercoaster Ride

Based on closing prices, the iShares PHLX Semiconductor ETF (SOXX) fell to a year-to-date loss of nearly 3% on February 8, then jumped to a peak YTD gain of almost 16% on March 12, per Yahoo Finance. Since then, after a series of wide swings, including a revisiting of negative territory, the ETF closed on May 18 with a YTD gain of roughly 8%. The index gained on Monday. By comparison, the S&P 500 was up by 2% YTD.

SOXX Chart

SOXX data by YCharts

Hedging Strategy

Mandy Xu, a derivatives strategist at Credit Suisse, proposed a set of options trades using the VanEck Vectors Semiconductor ETF (SMH) for investors who are optimistic about semiconductor stocks. It involves buying a call option with a strike price of $110 and selling a call option with a strike price of $120. The Barron's article was published on May 17, at which time the VanEck ETF was trading at a value of around $106. It closed at $106.05 on May 21.

According to Xu, the trade would be most profitable if the ETF enjoys a 15% price gain over the next three months, which would place its value at around $122. If the ETF fails to reach a value of $110, the maximum loss that the investor can suffer would be equal to net option premium paid, minus transaction costs such as brokerage commissions.

Based on a measure known as skew, Credit Suisse finds, per Barron's, that the cost of hedging against a decline in the VanEck ETF is near its lowest level in a year. "That indicates that investors aren't paying up for protection," Barron's says, creating a situation that cautious investors can exploit.

The Case for Chip Stocks

The VanEck contains the 25 largest U.S.-listed semiconductor stocks by market capitalization, while the SOXX consists of the 30 largest. Meanwhile, veteran tech fund manager Paul Wick has indicated that "semiconductors are an inexpensive way to play a lot of the best secular trends in technology." (For more, see also: 5 Stocks To Ride The Hottest Tech Trends: Wick.)

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