Wednesday, March 5, 2014

Smart or Lucky?

I am once again in the process of learning enough about options to feel comfortable about experimenting with covered calls, the simplest and safest option strategy. Several years ago, I felt I had learned enough to give it a try. I called up my broker and paid him to execute the trade to make sure I didn’t make a mistake. Turns out he made a mistake. It only took him 20 seconds or so to realize he had fouled up, but in those 20 seconds I lost $90 plus the cost of two trades. My broker was very apologetic and immediately refunded all of my money. He was a professional in every sense of the word. However, the experience spooked me. Over time I forgot most of what I had learned about options.

This morning I listened to an interview with Mark Cuban, the eccentric owner of the Dallas Mavericks. One of the subjects mentioned in passing was his Yahoo stock trade. Turns out this is considered to be one of the top 10 stock trades in history. Mark Cuban pretty much laughed it off. He said he was just lucky. He said if he had waited 6 weeks he never would have been able to execute such a trade. Of course I had to learn more.

Here is the story. I have read several different articles, but most of this information will come from Investment XYZ.

In 1995 Mark Cuban and Todd Wagner started an early version of YouTube called They sold their stake in the company to Yahoo! for $5.7 Billion in Yahoo! stock. At the time Yahoo! was worth about $130 Billion. It went up to $300 Billion then crashed to about $10 Billion. The Internet bubble was making Mark Cuban nervous. He decided to protect his 14.6 million shares of Yahoo! with an options strategy called a “collar.”

He sold out of the money call options on his shares. “Out of the money” means that the strike price is higher than the current market price. The value of a share of Yahoo! at the time was $95. The strike price for the call was $205. That means that if the price exceeds $205, the individual who bought the call option will execute his right to call away Mark Cuban’s shares at $205. Simultaneously, Cuban bought out of the money put options to cover a potential drop in the price of Yahoo! shares. These put options had a strike price of $85 a share, guaranteeing that Mark Cuban could not possibly lose more than $10 on a share of stock. He sold an identical number of 146,000 call contracts and bought 146,000 put contracts. These were all three year contracts.

Here is where it gets interesting. The cost of the puts exactly offset the income generated by the calls. The cost of this transaction was ZERO! No one is sure if the cost of the brokerage commissions was rolled up into this deal or not, but most suspect the parties involved included the commissions as part of the entire package. If you can swing somewhere around $1.4 Billion for a single stock trade, you can get a better deal than if you are trading $10,000 at a time.

After entering the “collar” Yahoo! share prices reached $237. If Mark had to sell his shares at the agreed upon price of $205, that would lock in a final value of around $3.0 Billion less commissions. The details of the execution get a little hazy and vary a bit from telling to telling, but everyone is pretty clear that Mark Cuban walked away with at least $2.5 Billion after all the dust settled. Soon after this event the Internet bubble burst. Yahoo! shares dropped to $13 a share. If Cuban held on the value of his shares would have dropped to $190 Million. He would have been comfortable, but he would have never become the owner of the Dallas Mavericks or the star of a reality TV show. Some of the minority partners and early employees of were wiped out. Mark looked very unhappy as he remembered how these events hurt others whom he seemed to care about. It was pretty obvious he did not want to talk about it.

The author of the Investment XYZ article notes that while it seems selling a $110 out of the money call for the same price as he paid for a $10 out of the money put might seem weird, it can be explained by a market phenomenon called “skew.” The market always places a higher value on downside protection than it does on than upside potential. The author also explores the hidden cost, loss of interest income that Cuban could have enjoyed by modifying the basic deal. He expects Cuban left somewhere around $200 Million on the table. Kind of like if I said Joe Montana could have done a better job in Super Bowl XXIV. His quarterback rating was only 147.6! Finally the author notes we will never know exactly all the details of who made and lost what in this deal, since the participants would have certainly hedged their initial positions just as Mark Cuban hedged his initial stake in Yahoo!

Once again stories like this raise the smart or lucky question. I guess the answer is both. The next question is the effect of hard work, study, and business smarts has on luck. Mark Cuban is notoriously competitive both as a businessman and as a sports team owner. He plays to win. Evidently he has a personal thing going with Donald Trump. They love to needle each other after one of them fails at something. After Cuban’s first TV show flopped, Donald Trump sent him a nasty letter. Cuban had it framed. It is one of only two items that always sit on his desk. The second item is the trophy from the Dallas Maverick’s championship. Cuban celebrated that victory with a $90,000 bottle of champagne he drank in a Miami nightclub where he had previously been razzed by Miami Heat fans.

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