Options for the Bold
by Richard
Well, now we know why the very rich are so very rich. They move with very bold and deft strokes. Famed corporate raider Carl Icahn is in the news again (Wall Street Journal, 5/16/08, page C3) as he prepares to wage a proxy fight with Yahoo, after they bungled their opportunity to be acquired by Microsoft for a substantial premium.
The best of the raiders and hedge funds perform a valuable function, which is to hold incompetent CEOs and their compliant boards accountable. They are not dismayed if they ruffle any feathers in the process. They hold their target’s flat feet to the fire until they achieve victory.
This is how markets sort out the winners and losers.
They are like Recon Marines and NFL defensive linemen. Their job is primarily to break things and put some hurt on their opponent.
What is unique about Icahn’s approach is his use of options to magnify his leverage to force Yahoo back to the bargaining table.
You will recall from our earlier post(s) on options, that you can bet on a stock going up by buying calls, or selling puts. Reversing the order, selling calls or buying puts is both a bet on the downside, or more commonly, a means of hedging an existing position against potential loss.
The range of possibilities grows geometrically when you throw into the mix various strike prices and expiration dates.
American versus European Options
And now we can throw a new variable into the mix: American vs. European style options. When the CBOE (Chicago Board Options Exchange) came out with standard contracts that could be traded on a central exchange, they ignited a boom in options.
Part of the package was the ability to close out positions well in advance of an expiration date, both for puts and calls. Simply stated, if you felt that your exposure placed you at risk, you could close out your bet by placing a “cancelling” trade of equal magnitude. That is, you could buy back the exact same Put or Call that you had originally sold, and your position was cancelled out, and you could do this at any time during any normal trading hours, days or weeks or months before the due date.
European options differ, in that settlement does not take place before the contract is due.
This is an important distinction.
The Icahn Strategy
Icahn bought 49 million American style Call options ( a bet on Yahoo going up) while simultaneously selling 49 million European style Put options (yet another bet on Yahoo going up–but one that cannot be settled before November 5, 2010.)
As these trades were simultaneous, the income from the Puts sold will offset the costs of the Calls bought.
Already, there is a bump in Yahoo’s share price, due to two factors. First, the sense that the deal with Microsoft was delayed, but not permanently derailed. This is what kept the stock from sinking to its “pre Microsoft bid” level.
Second is the fact that Icahn has put Yahoo back into play. This guy has a track record, and is one of the few players with the heft to move the needle on such a huge company.
The Bottom Line
If he is right, and the deal goes down, he will pocket the profit on the gain in his calls….and two years hence the puts he sold will expire worthless, so he will be off the hook and can pocket the proceeds he has already spent.
If he’s wrong, it’s the Calls that will expire worthless, with a strike price above market price, and he will be on the hook for any shortfall from the sold Puts. But with a cushion of two and a half years, there is still a likelihood that the Put strike price will hold.
Don’t worry if this makes your head hurt just to think about it. You and I are not going to run on the same track as the big dogs.
But you have to admire the sheer ingenuity, the daring and audacity.
Scott Fitzgerald said it best in his 1926 story The Rich Boy….
“Let me tell you about the very rich. They are different from you and me…
