Lessons from the famous 'Cuban collar'
Chris McKhann | firstname.lastname@example.org
Long before he became owner of the Dallas Mavericks, Cuban used the collar trade to lock in profits from his $5 billion-plus sale of Broadcast.com to Yahoo at the height of the dot-com bubble. The trade gave Cuban exposure to some upside but limited the downside in a position where he could not sell the stock because of his lock-up period.
This is obviously an extreme example, but it underscores for all of us the value of collar trades in situations where you must own the underlying. They can be designed in a variety of ways to protect positions and/or profits.
Of course, one of the great things about being a retail trader is that you usually don't have to hold onto such positions. And a bull call vertical spread has essentially the same profit/loss profile as a collar without the necessity of owning the stock. The margin requirements are also significantly lower on a call spread than on a collar. (See our Education section)
Still, there are other lessons to be learned about the Cuban trade, including the concept of the zero-sum game. This is an idea that trips up a lot of new players in the option market.
If we flip a coin and I get $1 on heads and you get $1 on tails, that is a zero-sum game. But people use options in different ways and for different reasons, so it is far more complex than that.
For instance, when we write about an institution buying or selling a seemingly unusual call or put position, we often get asked about it. (Usually it is the odd out-of-the-money puts that draw the most questions, but calls make for a better example here.)
Back on Dec. 30 we could have bought a SPY March 128 call for $4 with the SPY trading at $126. On March 1, it was worth $10 with the SPY up at $137 or so. So the call buyer profited and the call seller lost--right? Well, not necessarilly.
Certainly the outright buyers profited if they had held the calls. They made $6 on a $9 stock move, but it was a 150 percent option profit. Even as time decay accelerated, the calls went further into the money and produced profits.
But if sellers simply did the trade as a covered call, they profited too. They would have made $2 on the stock move up to $128 and the credit of $4 from selling the call, also for a profit of $6.
The call seller could also have been delta-hedged, which is what market makers do. When you buy a call, the other side of the trade is almost certainly a market maker who immediately hedges the sale with with stock. Such hedged positions are essentially selling the implied volatility of the stock and collecting the actual volatility--making profit on the ultimate difference between the two.
The implied volatility of the SPY options at the end of 2011 was around 22 percent, while the actual volatility last week was less than 8 percent. So the dealer who sold the call and delta-hedged it also made a very nice profit.
Just because one person turns a profit on options, it doesn't necessarily mean that money was lost on the other side of the trade. Of course, being realistic, it is entirely possible that both sides lose on the play as well.
That's why it's so misleading to call this a simple zero-sum game.
(A version of this article appeared in optionMONSTER's What's the Trade? newsletter of March 9.)