A Lesson In Option Pricing | The Acquirer's Multiple®

In their recent episode of the VALUE: After Hours Podcast, Taylor, Mitchell, Brewster, and Carlisle discussed A Lesson In Option Pricing. Here’s an excerpt from the episode:

Michael: It was so dumb on Qurate. It was right in those puts feeling like a hero, and it worked out quite well. It was the stupidest move. I should have bought the calls. You had the trade, what are you doing? [laughs] It’s like, what are you doing?

Bill: No, no, no. Wait. Will you talk about why you did that?

Michael: Broke the puts?

Bill: Yeah, because I think that that’s an interesting insight that you had into option pricing.

Michael: Yeah.

Bill: [crosstalk] we were talking about it.

Michael: For me with options, I view options, especially, your short-term options as being priced perfectly efficiently mathematically. It’s priced based on historical volatility, and so when I look at options, I almost never buy them, and I almost never sell them. When I look at them, I think I’m going to mispronounce his name, but Ben [unintelligible [00:11:42], his name. In my mind, I assume that when I’m buying or selling an option, I’m buying or selling it to or from him. He’s a lot smarter than I am. That’s his entire job.

So, I only venture when I think that there’s a chance that I know something that Ben doesn’t know. It’s something in the business or in the world in security changes and structurally changes what you think the future pricing of that option is going to be. The models that price options are computers that trade those, trade them perfectly based on historical information. But if the future is going to look very different, that’s just lifted from Greenblatt. That’s not me. That’s directly from the pages of You Can Be a Stock Market Genius.

For Qurate, and for the spins, and special dividends, the options price based on the value of the equity– If the value of the equity is going to be returned to you in cash, if it’s going to be given to you in a different security, like a security in a different type of a business, then you can– What I saw specifically in Qurate is, it was a $10 common before this entire event happened. I could write a put and struck at 10 bucks for $2.35. So, think of it as a 23% premium, and it was about 18 months of duration. Forgetting whether that was a good price, 23% for 18 months was a good price or a bad price, forgetting that for a second, what I knew was if you just waited a month, they were going to send back $4 of your what was it, $4.50, Bill?

Bill: Yeah.

Michael: The $3 preferred, $1.50 in cash. In my mind, I was like, “Well, I’m not insuring $10 of equity here. I’m ensuring $5.50 of equity.” Now, you’re paying me $2.35 to insure $5.50 in equity that I feel pretty good about, it’s two times earnings. By the way, give me that premium, and then the thing does crater, it’s like I basically am buying stock at one times earnings. Is that a good price? I was like, “Well, that makes sense to me to do that.” Then, I also have the view, as you know, as you shared that, there was a good chance more capital could be coming back.

And sure enough, that’s exactly what happened. Instead of insuring 10, which is how the options market was pricing it, I was insuring immediately after this event, $5.50 in equity value, and then we got another $1.50. Actually now, that puts only insuring $4 of equity value, and it’s a $2.35 premium. So, it’s a 60% interest rate to insure that for 18 months. It just seemed that was probably mispriced, and then now of course because the equity went up, that’s basically [unintelligible [00:14:14] securities. That was a nice pay day. I wrote that I think 40,000 times something like that.

Bill: [laughs]

Michael: It could have been pretty good. It worked out. Worked out. Was that too much, try not to disclose that information.

Bill: No, no.

Tobias: In that scenario, you’re trying to clip out the vol rather than what buy it– You didn’t want to pay the vol on it.

Michael: Yeah, I probably could have– if I would go back and do a now postmortem, I think the conclusion I would have come to is, if you really believe– You had to understand too, I had 45% of my invested assets in the common as well. So, if you add it in the puts, if they got exercised even after the distribute, added the puts in after all the distributions, my exposure to the common would have still been 35% of my book, and the problem is it’s 35% if it doesn’t work, so it’s the worst case.

Psychologically, it messed with my head, but I think if I do my postmortem and went through this again, I think that conclusion I would have come to is like, “You’re an idiot. If you really believe in this, don’t put your exposure on the put. Put your exposure on the call and just burn the premium.” If it works, then you’re going to get the distributions, you get access to those distributions through the call, because the calls adjust, all the options adjust when the distributions are big enough. You’ll get exposure to that, and then of course, you can get leverage on the ops instead of thinking that the puts were mispriced. I can tell you the puts were wildly mispriced. It’s very rare that that happens, but they were wildly mispriced. I think they probably should have been 50 cents, 40 cents, and they were trading for $2.35. So, it seemed a pretty good short. That was basically my only real short last year and it ended up working out pretty well.

I think the answer would have been buy the calls rather than the puts. But you can find those– When you see these spends and splits, actually with AT&T-DISCA, if you were going to do something, that’s probably the play, is play it to the options. You could buy leaps on T for nothing. That was something I was looking at, and I haven’t done anything with it. But those options on big events can be wildly mispriced.

Wildly mispriced. I think options in general are not mispriced. I think if people like Ben, who figured that out really quick and they can take advantage of those mispricings, but if there’s a big change in the underlying business. In Qurate, there wasn’t a change in the business. There was just this huge change in how the equity was constructed. Which by the way, I tweeted this out last week, shoutout to Liberty, that’s fucking unbelievable what they did. Those preferred were trading for 16 and a half times earnings right now, 16 and a half times cash flow and the common’s still at 4, it’s just that worked.

Bill: Where are they trading, like 110?

Michael: 110, yield to redemption. This is the 10 year out redemption. I’m assuming not the five-year redemption option. You got to the 10-year option. I think it’s like 6.1. So, it’s about 6.1 yield to worst if you just import that into a multiple it’s probably close to 17 times now.

Bill: Dude, you know what’s crazy? Those traded down to 88 and the common traded down to 588.

Michael: You want to know what’s worse? Let’s talk about our Ls. I sold them at 91 the ones I got– [crosstalk]

Bill: That I remember when you said that. [chuckles]

Michael: Yeah, because it was taxes, right?

Bill: Doesn’t matter very much.

Michael: Yeah. I know.

Bill: But they remember when you did that.

Michael: My basis in those was allocated it like 117 or something. They had that basis out [unintelligible [00:17:39] 107. I had this big short-term loss, and I was like, “Awesome, I need short-term losses.” So, I sold them and just literally the second that my sale cleared, it went to 98 or something like that. I was smart enough, I bought them all back and more.

Bill: You know who called that right? SirBaby6. He was a–

Michael: Oh, yeah, SirBaby [crosstalk]

Bill: When those preps went down, he was like, “This is the bet.” I never saw the juice in the press. That was the problem for me.

Michael: Well, to be honest, the bet was actually just to take all your proceeds from the prep and put it in the comment.

Bill: Yeah.

Michael: It was a four bagger from the bottom, or three bagger from the bottom I think now. So, that actually was the common is the place to be but the press were– if you were just looking for safety and yield the press were great. I’m a little pissed that the press were now 110, because I was using them as a cash proxy at 110 and I’m no longer cash proxy as my security. Anyway, that’s put writing. It should have been called buying, it’s put writing. It worked.

Bill: Call buying’s a little more risky, though, in that situation.

Michael: Yeah.

Tobias: Well, it’s depends on the scenario, right?

Michael: Yeah, it depends on what happens. [laughs]

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