My ears perked up listening to Bill Ackman’s Herbalife presentation as he talked about his use of options as an investment vehicle in his bearish investment in the company. In October 2013, Ackman informed the limited partners of his hedge fund, Pershing Square, that he had closed about 40% of his fund’s short position in Herbalife (which had been suffering mark-to-market losses) and replaced it with long-dated, over-the-counter, out-of-the-money (OTM) put options.
Then, in January of this year, listed OTM put options in Herbalife saw an enormous spike in volume and pundits surmised that either Ackman was doubling down on his bearish bet, the counterparty broker was trying to “hedge out” its exposure to Ackman’s investment, or that there was another investor piling in on Ackman’s side.
Because this is a bearish position, there is no obligation for Pershing Square to file a form 13-D (required for investors holding more than 5% equity in a public company) or a 13-F (a quarterly listing of all stocks held by investment advisors). As such, we cannot look at detail at Ackman’s put positions*, but there are some interesting insights to be gleaned from the various announcements.
Decoding the press announcements gives a good view to how a well-informed institutional investor uses options in an investing program. Let’s look at three things in particular–the market in which Ackman is transacting, his strike selection, and the large listed transaction.
Looking at only the market for listed options, institutional investors can get the wrong impression that the options market doesn’t have much liquidity. But trading volume and open interest in the listed market is only a small part of the total option market. Brokers offer what is termed “listed look-alike” contracts that allow for institutional investors to get option exposure without ever trading listed contracts–it is undoubtedly listed look-alike options that Ackman has used to make his bearish investment in Herbalife.
The advantages of listed-look-alike contracts include their flexibility and their greater liquidity. Disadvantages include counterparty risk and lack of anonymity.
Regarding flexibility, unlike listed options–whose tenors, strike prices, and contract sizes are standardized–all these elements of listed look-alike options may be customized to the needs and desires of the investment manager. Ackman’s letter talks about the possibility of extending the tenor of the option contracts in the future, and this is one example of the flexibility that listed look-alike contracts allow.
Liquidity in options is directly proportional to liquidity in the underlying stock (I will discuss why in my next post on Ackman’s Target options), so as long as there is a liquid market for the stock, you can generally get a liquid market for the options as well. Note that for bearish positions using put options, a stock being hard to borrow will increase the cost of the put and perhaps make it impossible to buy a put option in the notional value desired.
As for the shortcomings of listed look-alike options, obviously, any over-the-counter instrument carries with it counterparty risk. You would have not wanted to have Lehman Brother’s as a counterparty to listed-look-alike options in September 2008, for example. In order to transact in listed look-alike contracts, an ISDA master agreement be on file between the investment manager and broker and the broker will subject the manager to due diligence screening and enforce position size limits.
Obviously, too, if you are transacting one-to-one with a counterparty, that counterparty knows the size and nature of your investment–a difficult pill to swallow for many investment managers, who like to play it close to the chest about their portfolio.
This weakness can be ameliorated by splitting orders between brokers and / or by using some listed contracts to supplement a listed look-alike position. Hedges can be done using ETFs or custom baskets of stocks that may or may not contain one’s own holding. While this type of a hedge does not protect a manager from idiosyncratic risk (i.e., the risk of a stock-specific event), it does protect from structural shocks and has the additional advantage of being proportionally less expensive than an option on a single name.
Seeing that Ackman’s options were OTM was a bit of a surprise to me, and I can’t help but think that he would be better served by an ITM put in this case. OTM options do carry a large amount of leverage, so price changes (on both the profit and loss sides) can be very sudden.
However, time value–which is what you are paying for when you buy an OTM option–represents an immediate loss of capital. Yes, this loss of capital can be offset later with profit on the position, but money spent on time value is essentially a sunk cost. Using OTM options also creates added pressure to be right on the selection of option tenor, and this is something that I believe is difficult or impossible to do well.
It is interesting to note that Ackman used ITM options for his investment in Target. I’ll review the thinking behind that strategy in my next post.
Listed Option Transaction
I would be surprised if the large listed option transaction in January was the broker hedging out the short put exposure to Ackman, but this is not impossible.**
I would also be surprised if the purchaser was Ackman, simply because it is a bit ham-fisted and transacting in the listed market would not give Pershing Square an economic advantage compared to trading in the listed look-alike market.
This leaves the possibility that someone else is piling into the transaction–the scenario I think is most likely.
A trade of this size, first and foremost, is making a statement. The owner of these puts likely hoped that his or her bold option market statement would have an effect on the stock market–that the tail would wag the dog, in other words. (There is some evidence that this tail-wags-dog phenomenon has been occurring more often, as hedge funds realize that other investors believe there is informational content in large option trades.)
And while the stock price has indeed declined a good bit since January, the 50-strike puts have still lost money due to lowered implied volatility and the inexorable wasting away of time value.***
While there is not enough transparency to know exactly what is going on in Ackman’s Herbalife transaction, understanding the implications of the facts that are known allows intelligent investors to have a better grasp of how the option market works, especially in an institutional context.
* I will have a follow-up post on Ackman’s long call position in Target (TGT). These positions were well documented because they were bullish positions that would have resulted in ownership and control were they to have been exercised. Thanks to this documentation, the follow-up post will contain more specific numbers and detailed comments.
** Usually brokers protect themselves from stock price exposure through something known as delta-hedging and delta-hedging can be done by (in this case) selling Herbalife shares. However, delta hedging cannot protect a broker from what is called “gamma risk”–the risk of a sudden, discontinuous stock price move. According to MSN the top four holders of Herbalife’s stock hold around 40% of the shares outstanding, and such concentrated positions do sometimes portend big sudden price moves (e.g., negotiated sales at a lower price, etc.). However, the fact that this transaction was done in the listed market and is such an enormous trade vis-a-vis open interest and normal volume makes me think that a broker would have taken another route to hedge the gamma exposure.
*** In my book, The Framework Investing, I provide a section that clearly and memorably illustrates how changing market conditions change the price of options.