The Trump Force Awakens
A month after the election, the culture war continues between Donald Trump supporters and certain businesses they perceive as their opposition. First came calls for a GrubHub (NYSE:GRUB) boycott. Then, the Trump Train targeted PepsiCo (NYSE:PEP). In both of those cases, the boycott calls were prompted by comments made by the companies' respective CEOs about the election of Donald Trump. Next was a call for a boycott against Kellogg (NYSE:K) after the company announced it would no longer advertise on Breitbart, the news site formerly run by president-elect Trump's chief strategist Steve Bannon (Trump Train Targets Kellogg). On Thursday, Trump supporters targeted Disney's (NYSE:DIS) Star Wars franchise, making #DumpStarWars the top hashtag on Twitter (NYSE:TWTR).
The timing of this boycott seems a bit odd, as it appears to have been prompted by a November 11th article in the Hollywood Reporter about next year's "Rogue One" Star Wars movie ("'Rogue One' Writers Subtly Protest Trump With Rebellion Safety-Pin Logo").
Jack Posobiec, the Trump supporter in the screen capture above, claimed that the studio had reshot part of the movie to make it explicitly anti-Trump; Rogue One screenwriter Chris Weitz denied that. But any Trump supporters perusing Weitz's Twitter page for his denial will find other political tweets that will annoy them.
We'll have to wait until Disney reports results from the current quarter to see if this boycott has any impact on its revenues, but presumably, we could see an impact on share price before then. We haven't seen big moves in the other three companies targeted for boycotts, but all have lagged the SPDR S&P 500 ETF (NYSEARCA:SPY) since the election.
Whether or not this boycott ends up having a material impact on Disney, there are a couple of other reasons why longs may want to consider hedging here:
- Disney's valuation looks extended by some measures.
- It's inexpensive to hedge now.
For valuation, we've been experimenting with a new site to visualize relevant metrics, Simply Wall Street (we have an affiliate relationship with them and may be compensated if readers sign up for one of their premium products). As the graphic below shows, Disney is currently overvalued on a discounted cash flow valuation basis:
Market valuation is more of a mixed picture, with Disney comparing favorably to the media industry and the broader market on trailing earnings, but unfavorably on Price/Earnings/Growth and Price/Book measures.
We've included a quick refresher on hedging terms below before we get to the inexpensive hedges for Disney.
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 can also 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 15%. 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 Thursday's close to hedge 1,000 shares of DIS against a greater-than-15% drop by mid-June:
As you can see at the bottom of the screen capture above, the cost of this protection was $1,680 or 1.63% of position value. A few points about this hedge:
- 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).
- The 15% threshold includes this cost, i.e., in the worst-case scenario, your DIS position would be down 13.37%, not including the hedging cost.
- 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 7% for it. The potential return by mid-June implied by Wall Street's consensus 12-month return for the stock (pictured below, via Nasdaq) was essentially flat.
We were able to raise the cap to 11% without raising the hedging cost, so we used that.
As of Thursday's close, this was the optimal collar to hedge 1,000 shares of DIS against a greater-than-15% drop by mid-June while not capping an investor's upside at less than 11% 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 the same as in the optimal put hedge above, $1,680, or 1.63% of position value. But if you look at the second part of the collar below, you'll see the income generated from selling the call leg was exactly the same.
So the net cost was $0. 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 collected a net credit when opening this hedge.