Downside Protection For Disney

| About: The Walt (DIS)

Summary

With Disney set to release earnings after the close, crowd-sourced startup Estimize expects it to beat Wall Street's consensus by 2 cents per share.

Seeking Alpha contributor Reuben Gregg Brewer remains long Disney, but suggests shareholders keep an eye on the implications for the space of Hasbro's purchase of an animation studio.

For Disney longs looking to add downside protection, we present two ways of doing so.

Disney characters wallpaper via Bing. Click to enlarge

If guests have the nerve to die, they wait, like unwanted calories, until they've crossed the line and can do so safely off the property. - The Project On Disney, via Snopes

Estimize Is Bullish On Disney's Earnings

With Disney (NYSE:DIS) reporting earnings after the close, the 1,446 Disney analysts reporting to Estimize collectively predict the company will beat Wall Street's consensus earnings estimate, as the graph below shows.

The Estimize consensus earnings estimate shown above, $1.63, is 2 cents ahead of the Wall Street consensus of $1.61. Since its analysts include private investors as well as those from independent research shops, buy-side firms and sell-side firms, Estimize says its estimates tend to be more accurate than those from Wall Street analysts alone. In fact, the most accurate of Estimize's Disney analysts over the last 4 quarters has been a college student, a finance major at Indiana University named Ross Linton.

A New Risk In An Emerging Competitor?

On Monday, Seeking Alpha contributor Reuben Gregg Brewer wrote about Disney partner Hasbro's (NASDAQ:HAS) purchase of animation studio Boulder Media and asked if that meant Hasbro was emerging as a new competitor to Disney. Brewer, who is long Disney, concluded:

It's too soon to tell what's going to happen as Hasbro more aggressively seeks to shift into the media space. But for Disney shareholders, who may not think too much about Hasbro, it's really a move worth watching. It portends a shifting landscape in toys and media that could have material implications for Disney, let alone other media-focused names. I wouldn't call it a big risk right now, but I wouldn't ignore it, either.

Limiting Downside Risk For Disney Longs

For Disney longs boosted by the bullish Estimize earnings prediction, but looking to hedge their downside risk over the next several months in light of the "shifting landscape in toys and media" Brewer noted, or out of concern for current market levels, we'll look at a couple of ways of doing so below the refresher on hedging terms.

Refresher On Hedging Terms

Recall that puts (short for put options) are contracts that give an investor the right to sell a security for a specified price (the strike price) before a specified date (the expiration date). And calls (short for call options) are contracts that give an investor the right to buy a security for a specified price before a specified date. Optimal puts are the ones that will give you the level of protection you want at the lowest cost.

A collar is a type of hedge in which you buy a put option for protection, and at the same time, sell a call option, which gives another investor the right to buy the security from you at a higher strike price by the same expiration date. The proceeds from selling the call option can offset at least part of the cost of buying the put option. An optimal collar is a collar that will give you the level of protection you want at the lowest cost while not capping your possible upside by the expiration date of the hedge by more than you specify. In a nutshell, with a collar, you may be able to reduce the cost of hedging in return for giving up some possible upside.

Hedging Disney With Optimal Puts

We're going to use Portfolio Armor's iOS app to find an optimal put and an optimal collar to hedge Disney, but you don't need the app for this. You can find optimal puts and collars yourself by using the process we outlined in this article if you're willing to do the work. Whether you run the calculations yourself using the process we outlined or use the app, another number you'll need (along with the number of shares you're looking to hedge) when scanning for optimal puts is your "threshold," which refers to the maximum decline you are willing to risk.

This will vary depending on your risk tolerance. For the purpose of the examples below, we've used a threshold of 14%. If you are more risk-averse, you could use a smaller threshold. And if you are less risk-averse, you could use a larger one. All else equal, though, the higher the threshold, the cheaper it will be to hedge.

Here are the optimal puts as of Monday's close to hedge 500 shares of DIS against a greater-than-14% drop by late January.

As you can see at the bottom of the screen capture above, the cost of this protection was $980 or 2.05% of position value. A few points about this hedge:

  1. To be conservative, the cost was based on the ask price of the put. In practice, you can often buy puts for less (at some price between the bid and ask).
  2. The 14% threshold includes this cost, i.e., in the worst-case scenario, your DIS position would be down 11.95%, not including the hedging cost.
  3. The threshold is based on the intrinsic value of the puts, so they may provide more protection than promised if the investor exits after the underlying security declines in the near term, when the puts may still have significant time value.

Hedging Disney With An Optimal Collar

When searching for an optimal collar, you'll need one more number in addition to your threshold, your "cap," which refers to the maximum upside you are willing to limit yourself to if the underlying security appreciates significantly. A logical starting point for the cap is your estimate of how the security will perform over the time period of the hedge. You don't think the security is going to do better than that anyway, so you're willing to sell someone else the right to call it away if it does better than that.

We checked Portfolio Armor's website to get an estimate of Disney's potential return over the time frame of the hedge. Every trading day, the site runs two screens to avoid riskier investments on every hedgeable security in the U.S., and then ranks the ones that pass by their potential return. Disney passed the two screens, and the site calculated a potential return of 5.3% for it. The potential return by late January implied by Wall Street's consensus 12-month return for the stock (pictured below, via Nasdaq) was about 8%.

Click to enlarge

We were able to raise the cap to 9% without raising the hedging cost, so we used that.

As of Monday's close, this was the optimal collar to hedge 500 shares of DIS against a greater-than-14% drop by late January, while not capping an investor's upside at less than 9% by the end of that time period.

As you can see in the first part of the collar above, the cost of the put leg was $775 or 1.62% of position value. But if you look at the second part of the collar below, you'll see the income generated by selling the call leg was $700 or 1.46% of position value.

So, the net cost was $75 or 0.16% of position value. Two notes on this hedge:

  • Similar to the situation with the optimal puts, to be conservative, the cost of the optimal collar was calculated using the ask price of the puts and the bid price of the calls. In practice, an investor can often buy puts for less and sell calls for more (again, at some price between the bid and the ask), so in reality, an investor would likely have paid less than $75 when opening this collar.
  • As with the optimal puts above, this hedge may provide more protection than promised if the investor exits after the underlying security declines in the near future, due to time value (for an example of this, see this article, Hedging Apple). However, if the underlying security spikes in the near future, time value can have the opposite effect, making it costly to exit the position early (for an example of this, see this article on hedging Facebook, Facebook Rewards Cautious Investors Less).

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.